This is News??

I am currently very busy with a couple of projects, so my posts are necessarily short.

This morning I was struck by the headline of an article appearing on the NY Times: "Chinese Stocks Fall For 2nd Straight Day". The article's content is not as important as the message conveyed by the choice of title: a two day drop in Chinese stocks is major news! This is how far the stock mania has reached, that consecutive new highs are the expected norm and "corrections" are newsworthy aberrations?

Naturally, US markets reacted with a new all time high. Why? Because speculators have now "learned" from the previous Chinese episode in February-March that all is OK and that they should "buy on dips." Is so much conviction a sign of a healthy market? Or is it a delusion?

As the steamboat card sharpies accurately said, "you pays your money, you takes your chances." It is just that the odds are getting shorter these days , as current and former market regulators and central bankers all over the world are constantly reminding us. Except in the US, of course, where Greenspan is - once again - publicly ignored (and privately ridiculed) for his current version of "irrational exuberance" warnings. The rest are force-feeding the goose in the hopes it lays a clutch of golden eggs in the form of broad hoi polloi market participation, before it gets slaughtered and its liver becomes pate.

I, however, believe that il popolo at large has no extra money to invest (e.g. negative saving rate) and at best is simply buying on margin (new all time record in NYSE margin in April, $318 billion).

The real action is coming from leveraged hedgies plus foreigners re-investing the money gained from selling fluffy toys and flat screens to American consumers. In other words, the party is going on with very few party-goers in the nightclub, who have turned up the music volume to attract the passers-by. The role of Street "barker" has been given to the private equity funds..."Hey, hey, checkit out, checkit out .. 18.6 billion for this one, 32 billion for the other, how about this beauty, eh? Gotta be worth at least a fiddy, whaddaya say? C'mon, lotsa bootiful opportunities inside..."

Looks to me like they are putting lipstick on a whole lot of geese these days. But, hey, what do I know? Ask Hank.

Byzantine Monetary Policy

I was listening to the car radio yesterday when I chanced upon a historian explaining the reasons for the decline and fall of the Eastern Roman Empire, also known as the Byzantine Empire. What caught my attention was this: she quoted a 7th Century chronicler who maintained that the Roman Empire would never fall because: "...it puts its faith in God and its currency is the mainstay of global commerce". Fancy that... even 1300 years ago smart people knew that the Empire's foundation was God and Gold, i.e. their very own Solidus Hegemony.

Indeed, the Eastern Empire flourished and its coinage was used from China to Britain for centuries. But as troubles descended on Byzantium in the 11th Century, the gold coinage was seriously debased with silver, whilst lower value silver coins were debased with copper. Constantinople's (Istanbul) final fall to the Ottoman Turks exactly 554 years ago on May 29, 1453 was a mere formality, for the Empire had in reality ceased to exist long before that.

And what about today? Our global currency is imprinted with the words "In God We Trust" and can be found from the factories of Chongqing to the oil wells of Kuwait. And just like some unfortunate Byzantine Logothetes of The Treasury, Hank Paulson is engineering the debasement of the dollar - how many trips to China does it take to accomplish it? Because, make no mistake, "re-valuing" the yuan means devaluing a dollar that can no longer purchase as much as it used to.

History rhymes, indeed...Sic transit gloria mundi.

Now Read This

Back from the holiday and there is not much new to say, so I will turn to that old standby: OPB's (Other Peoples' Books).

I recently read "China Shakes The World - The Rise Of A Hungry Nation" by James Kynge (Phoenix, 2007) and I strongly recommend it to anyone who wishes to have a clear understanding of the economic juggernaut that is steam-rolling across the globe. It is written by the former Financial Times Beijing bureau chief in a lucid, arrestingly readable style that provides personal vignettes and broader spectrum observations. Mr. Kynge has a deep knowledge of China having been there since 1982, way before the dragon even started stirring.

Some quick take-aways:

• There is enormous excess manufacturing capacity in everything. Domestic prices are extremely cheap so exports are the only way to profit.
  
• Industry is massively subsidised through below-cost electricity, water, coal, fuel, the absence of labor union wage bargaining and environmental regulations.
  
• China must create 24 million new jobs every year, just to stay even.
• Since there are few, if any, globally recognised Chinese brands manufacturers compete solely on price. Even a modest yuan appreciation could wipe out their profit margins.

There is much more to read and appreciate in this book, particularly the personal rags to riches stories which form its backbone and make it difficult to put down. In addition, is well balanced and steers away from the polemics common to current books on China.

Where's The Debt Going?

I have posted various debt statistics before, but perhaps the single most troubling one is that of debt intensity of economic growth, i.e. how much additional debt is taken on to generate one more dollar of GDP (see chart below - click to enlarge).

US Debt Intensity of GDP Growth

It now takes roughly 5 dollars of new debt to generate 1 more dollar of GDP. In gross dollar terms, during 2006 total debt grew by $3.55 trillion whereas GDP grew by just $0.79 trillion. Notice how GDP growth in dollar terms has been stuck in the same place for 4 years running, whereas debt growth has moved steadily upwards.

Which begs the question: where does all this added debt go, since it does not get consumed or invested in plant and equipment (it would have shown up as GDP growth)? And what are the final consequences if this imbalance keeps going on? These are truly not easy questions, so I will leave them open for your comments...

P.S. There are no singular "correct" answers. There is the "easy" Ponzi answer, i.e. issuing more debt to pay interest on existing debt, but I think there are more elements at play here, particularly in the nature of the debt itself (e.g. financial vs. non-financial in origin).

Bubbles, Bubbles Everywhere...

The noted money manager Marc Faber recently said in a Bloomberg TV interview that he sees asset bubbles everywhere: stocks, bonds, commodities, precious metals, real estate, art, wine. The only asset he perceives as reasonably priced is real estate in Detroit and farmland, so he urges everyone to learn how to drive a farm tractor.

Naturally, the numerous concurrent asset bubbles are primarily a sign of the massive global bubble in "money": the unprecedented liquidity caused by massive US deficits and powered by low real interest rates. All this debt-created money is further pumped up by speculative leverage (e.g. yen carry, derivative sales, etc) and all of it together is being flung onto every asset there is, in an attempt to maximize trading gains.

And therein lies the first paradox: on a risk adjusted basis plain old cash is a rather attractive right now, what with dollars yielding 5.25%, euros 3.75%, sterling 5.5% and even yuan 3.06% and rising. Is that so bad? Only in a context of expectations of continuous double digit annual returns: i.e. there is a concurrent global bubble in greed, too. (Let me put it this way: It is estimated that profits for S&P 500 companies will grow by about 7% this year, around 2% over cash. Is that worth taking the added risk?)

The yen is admittedly still a horror show at 0.50% and if there was a prize given for the world's most inept central bank BOJ would have won it every single year since the late 1980's (I am being unfair here, but only a little). I mean, those guys have let their once proud currency become the cheapest harlot in global finance: everyone is enjoying the yen's services and paying next to nothing. (The clients are not using any protection, either, so next it's going to be the pox for everyone, but this is a family oriented site, so enough said.) Cheap loans in yen are used as a booster rocket for global liquidity to achieve even higher marginal rates of return, at the cost of yet another layer of risk, of course.

And there is a second paradox: as money pours into the market, the perception of risk - at least as measured by credit default indexes - is reduced, instead of going up. Credit default swaps (CDS) were initially created as a means of transferring credit risk between parties, but they have now become an asset class by themselves (eg CDO's backed by CDS's) and they, too, have benefited tremendously from the increased liquidity. Therefore, their current prices are not reflective of fundamentally lower credit risk, but of their high demand as assets to create all kinds of structured securities.

In sum, we have concurrent bubbles in liquidity, greed and risk-perception. They are highly correlated to one another and have created a bullish momentum that feeds on itself, mostly ignoring fundamental economic and geopolitical realities (e.g. US slowdown, China's manufacturing overcapacity, Iran tensions...).

In their final stages all bubbles create their very own "bubble-reality"; when they pop the "real- reality" takes over and leads to collapse. Today's most dangerous bubble-reality is the firmly held conviction that there is so much liquidity that all assets MUST go up. This is a delusion.

The Price is Right (?)

Global equity markets are currently like a version of "The Price Is Right" gone terribly awry. As the regular contestants are busy trying to guess the correct retail price for a series of consumer products, a 5-ton male gorilla shows up. Completely disregarding the rules, every time a regular contestant bids $3.49 for, say, a can of hairspray the gorilla jumps up and down screaming "hunnerd bucks, hunnerd bucks I pay, mine, mine". A hapless Bob Barker tries to calm the animal down by explaining that this is just a game and not an auction, but the gorilla will have none of it. He smacks the table with his ham-fisted hands and demands that he MUST buy all the items on the show. Picking a fight with a male gorilla in heat is not wise, so the animal is rapidly accumulating a whole bunch of toothpastes, oven cleaners and cake mixes. In any case, he seems to have a rather unlimited supply of genuine, crisp "hunnerd" dollar bills so why pass up the huge mark-ups he is paying?

After their initial shock, the contestants are catching up, too: their handbags hold items the gorilla also wants - a tube of lipstick, a hairbrush, a package of moist towelettes - they are all going for a hunnerd bucks. The animal is ecstatic, wildly stuffing his purchases inside scores of Hefty(R) plastic bags (hunnerd a pack, naturally). Bob is not to be outdone, either: as the animal's attention is diverted by a contestant's particularly flashy key chain, he is seen calling his wife on the cell phone to stuff the SUV with every cleaning product they have in the house and rush down to the studio.

...and as the show's music changes to "Money For Nothing, Chimps For Free" Bob is rubbing his hands with glee. He is thinking: "This must be a good time to retire, let the damn gorilla have his way. What is he gonna do with all that cr*p, anyway?" The gorilla's backers, the ones providing all those freshly printed hundred dollar bills, must surely know a good deal when they see one, no?

N.B. The first time I saw the show (no gorilla) was in July 1974. After 35 years with the show, Bob Barker (a noted animal rights activist, no joke) is in fact retiring this May. Godspeed, Bob...

Household Equity Ownership: Direct vs. Indirect

In my post yesterday I said that retail investors are basically "out" of this market, at least directly, i.e. outside of their pension and other funds. One reader asked what the trend has been over the past few years, so here are a couple of charts. Data comes from the Fed's Z.1 Flow of Funds quarterly report.

Households' direct holdings of stocks peaked in 1999 and are now running at around half that level, while their indirect holdings through pension funds, insurance companies and various mutual funds are much higher and rising.

The total amount of equities currently owned by households is the same as in 1999, but direct ownership has dropped from 57% to 33% in 2006. The relative importance and decision-making power of institutional investors has increased greatly.

One consequence of this capital allocation shift is the phenomenal rise and empowerment of hedge funds ($1.5 trillion in assets), which now account for as much as 2/3's of daily volume in some markets. Such funds make great use of leverage through margin borrowing and derivatives, explaining in part why derivatives and "carry" trades have become so popular in the last few years.

There is also another, more qualitative, aspect to this development: institutions have very different investment behavior characteristics from individuals. First of all, it's not their money: if the ultimate owner wants his money back they have no choice but to liquidate positions. Second, they must always be invested: no one gives money to a manager to keep it in cash. Third, they are mostly driven by relative performance: jumping the gun on the competition is crucial. Put these traits together and you can see why institutions are always subject to the herd mentality.

The much maligned individual investor, on the other hand, is a very different kind of beast. Except for those rare delusional instances when they form a "crowd" (e.g. dotcom day traders in 1999-2000, China today), individuals actually act as shock absorbers to the institutions' excesses, exactly because they can decide and act on their own volition. They have the ability to zig when professionals must zag.

The individuals' much reduced direct exposure to the stock market perfectly explains what has happened since 2003 - the institutional herd got bigger and stronger and now rules the field. But this also points to something very worrisome: the individual's absence increases the risk of sharply higher volatility if/when market sentiment turns negative and the institutional herd runs for the exits. This lack of shock absorbers creates a systemic risk that no one is considering right now.

P.S. Today the PBoC did a monetary policy trifecta: It raised interest rates, raised bank reserve requirements and widened the yuan daily FX trading range. It's trying to cool down its economy, discourage rabid speculators and forestall US political pressure to impose trade sanctions. This is certainly much more than a warning shot across the bow, but will China's Golden Pig Year entrepreneurs and speculators pay any attention? They better, because it is becoming increasingly obvious that the authorities mean what they say.

Reality v. Hyper-Reality

For several months now the US economy has been steadily softening on the back of a real estate recession, the loss of manufacturing jobs, increased prices for fuel and food and, more recently, a developing stall in retail spending. And yet, stocks are making new highs - what gives?

There are two things happening at once:

1. Individual retail investors are largely absent, at least directly (i.e. outside their pension plans). This leaves the market in the hands of professionals, mostly hedge and private equity funds, i.e. momentum players who amplify existing trends.
   
2. The perceived and highly convenient wisdom among such professionals is that the economy is merely going through a temporary soft spot and will soon bounce back - with a boost from a Fed rate cut, if necessary. Thus, they hang on to stocks because current P/E's at around 18x (S&P 500) are not "expensive". Determined buying comes from M&A and LBO activity (i.e. spending OPM to make huge fees, no matter what the outcome).
   

But... what if the economy is headed towards deeper trouble than expected? What if the combination of (A) high debt + (B) negative saving + (C) lower home prices produces a stubborn consumer spending strike (70% of GDP)? Corporate profits will drop and "low" P/E's will prove very high in retrospect.

What are the chances of this happening? Comparisons with the Depression Era should always be taken with big grains of salt, but it is undeniable that the A+B+C combination has not been seen in the US since... the Great Depression. If the adverse effects of these conditions get established as negative consumer behavior it will be impossible to avoid a stubborn recession.

As a first sign, retail sales are already softening, running at +2-3% vs. last year, i.e. negative when inflation is accounted for (see post from May 11). I believe that such spending is the proverbial canary warning about overall consumer behavior, since cutting down on trips to the mall is the fastest way to achieve immediate savings. In fact, ShopperTrak reports that in April foot traffic at US retailers dropped 13% and sales rose a paltry 2.3% vs. last year. As usual, poor weather is being blamed, but if this persists for several more weeks we could see weakness spreading to other types of non-essential discretionary spending, i.e. services such as lawn care, gyms, car washes, hair and nail salons, etc.

In this respect, I am convinced that momentum players are not properly assessing the rising fundamental risks and are just looking to the market as a guide to the economy. The market's action has thus become disconnected from economic reality, as in "the economy is weak, but the market is up so the economy must be strong". This kind of circular logic is creating a fallacious hyper-reality of wishful self-fulfilment than can readjust suddenly and create a severe market correction.

Let me put it another way: "normal" market extremes are easy to identify because the greater public jumps in with both feet screaming with delight - it is happening in China right now. But the kind of "silent" extreme we are experiencing in US and EU markets right now, is contained within the cerebellums of the professional community and, in my opinion, has zero tolerance for error. If hyper-reality shifts to plain old reality, suddenly EVERYONE in the hedge/private/pension community will become a motivated seller but there will be no willing buyers because the individual investors are long gone and hurting from the popped housing bubble, besides.

Below are some plain "reality" charts:

RETAIL SALES

MFG. GOODS ORDERS

INDUSTRIAL PRODUCTION

DURABLE GOODS ORDERS, EX-AIRCRAFT

NEW HOUSING PERMITS

EMPLOYMENT

As for hyper-reality charts... look at any stock market index you choose. I like this one: The Shanghai SE "B" Index, up 75% in ONE MONTH.

SHANGHAI "B"

It's More Than Core

The government's (and markets') obsession with "core" inflation is outdated and misplaced. The real world has changed: the expansion of China and India means that growing scarcity and rising prices of natural resources (i.e. food and fuel) are now more important than before. After all, we can make do without a new pair of sneakers, but we can't survive without corn and oil.

For several decades now we have lived in The Age of More, as technology and copious energy inputs combined to produce more of everything. The Green Revolution kept real prices for food commodities at near record-low levels, even if prices for finished goods like cereals and juices kept rising to cover ancillary costs (e.g. marketing) and to boost corporate profits much above inflation.

But I sense a major shift coming: we may be about to enter The Age of Less. I certainly don't mean some apocalyptic version of Peak Everything that will rapidly deteriorate into social upheaval, as some doomers proclaim. Rather, I think we will be reverting back to "basics", where the rising price of food and fuel will diminish our ability to consume everything else with the same careless abandon we do now.

As such, I think we should start following more closely the "other" part of inflation - the one that we are told is too volatile to take seriously. In the chart below, notice the sharp upward change in trend for the Urban CPI that tracks commodities (such as food and fuel), from 2004 onwards.

In simple terms, the vast multitudes of China and India are keeping global wages and benefits subdued through their exports, while at the same time they exert upward pressure on resource prices from their raw material import demand.

Addendum: Jason B commented that college tuition should be included in CPI numbers. The data IS tracked by the BLS since 1978 and is thus probably already part of CPI calculations. See chart below (click to enlarge).

Finance Surfers

Think of global liquidity as a series of waves cresting and crashing on our shores, with hundreds of surfer-financiers delightedly rushing to frolic in the surf. What creates all those waves, where does the motion of the ocean come from?

In my opinion, there are currently two major wave machines and both are located in Asia: one is the yuan-dollar peg and the other is the grossly undervalued Japanese yen. The yen funds the "carry trade" that is responsible for speculation across the globe, while the mercantilistically pegged yuan creates a ready receptacle for dollar-denominated debt issued by governments and private institutions alike. In essence, the present situation of both currencies creates huge monetary imbalances that propagate across our interdependent economy, to end up as huge waves of liquidity on every shore on the planet.

Can the wave machines suddenly stop, causing the happy surfers to smack against the rocky outcroppings of Mavericks beach? Yes, they can and at least one of them - the yuan peg - looks like it's ready to conk out since the imbalances are now affecting China itself. I am referring to the rampant stock speculation mania that now grips the very soul of Chinese society (see previous posts), threatening the savings of tens of millions. In simple terms, the liquidity has turned inwards and is causing a flash flood of "hot" money.

Chinese authorities have spoken out firmly against such foolishness, but words have had no effect, so far. Individual speculators have morphed into a solid LeBon "crowd", with its own psychological attributes, chiefly that it does not listen to reason. Engulfed in passion, it completely disregards solid fact and chases after rumors, innuendoes and tips.

In every major bubble in history the pathways and outcomes are always the same: repeated warnings issued by authorities are ignored until regulators are finally forced to take drastic action to settle things down, precipitating a violent correction as drunk-happy speculators suddenly sober up and head for the exits en masse. The longer the action is delayed, the worse the correction and thus the potential damage to the economy.

In the case of China the only sensible thing to do is to revalue the yuan ASAP by a sizeable percentage, say 8-10%. It will not only send a stern message to rampaging speculators, it will also eliminate the rising pressure from the US Congress seeking to impose trade sanctions. It will also lead to a welcome shake-out in manufacturing, as borderline factories that depend solely on ultra-cheap labor to produce export goods drop out or, better yet, turn to the domestic market. One way or another, the rising overhang of production capacity will be absorbed or eliminated.

In the case of the yen, things may look different on the surface but they really aren't - it's just the mechanics that change. Again, the artificially low yen exchange rate is creating incoming liquidity from the export industry, which is then channelled to speculation through the yen carry trade, as both domestic and foreign speculators take advantage of low interest rates. In this case a bubble is not as apparent in domestic markets, because unlike the yuan the yen is freely exchangeable to any other currency and thus liquidity is spread out amongst all global financial markets, creating bubbles all over.

It is more difficult to regulate this yen liquidity because the Japanese domestic economy is certainly not as vibrant as China's and cannot easily withstand a major administrative hike in interest rates or an FX revaluation. And yet... this type of wave machine is also vulnerable: it may fall victim to its own success. There are now hundreds of billions of dollars of yen loans supporting speculative open market positions; if markets show major signs of weakness speculators will rush to repay margin loans, causing the yen to spike upwards. We saw this clearly in the February-March correction.

And what could bring about a major correction? Why, the other wave machine, of course... In a seeming paradox, a yuan reval may also cause the yen to move up and we may end up with BOTH wave machines seizing-up at the same time and liquidity waves suddenly disappearing all over the world.

In surfing terms, we won't have 50 ft mongo waves all day, everyday...

An Empire Needs More Than A Bathtub

A Sunday Sermon...

Decades of government-bashing has left most Americans (and many Europeans) convinced that "big government" is the Devil that lurks behind all societal and economic ills. Starting with Maggie Thatcher, neo-conservative reformists gripped society's attention with one hand tricks (low tax promises), while the other was busy chopping precious institutions and casting them to the free-market pyre. The torch was passed across the sea to Ronald Reagan, who then cunningly sneaked it into Clinton and Blair's hands (though the latter surely would deny it), only to end at the hands of George W. Bush: a social pyromaniac with a craving for ritualistic auto-da-fe's. Like Torquemada running the Jews out of Spain, neo-cons have twisted and expelled from mainstream public discourse the very thought and mention of a socially just state, casting it as sinful and heretical in the very eyes of those most likely to benefit from it. It was a propaganda job admirable for its effectiveness, but perniciously criminal in its results.

From the flood of debt that drowns 90% of the people, to the deluge and destruction of New Orleans; from the murder of innocents in Virginia and Columbine, to the internecine massacre of Iraq; from the trickery of Drexel, to the rape of Enron; from the banlieues of Paris, to the ghettos of East LA - the same dangerous ideology threads itself throughout the weft and wove of failed neo-con policies and politics: Government is evil, taxes are theft, the Ayn Rand individual is King and the Adam Smith market Divine.

To all those neo-Norquists out there, I ask a simple question: Do you think Empires can survive - never mind flourish - while drowning inside a bathtub?

And for the Treasury and Fed agonistes: Do you think you can run an Empire on a foreign-issued credit card... forever?

Obviously, No and No. The very survival of the global Empire that is now the United States is dependent on public strength and moral justice. It is time to demolish the rusting, foolish and selfish neo-con ideology and construct anew a rational tax policy, a sane trade policy and a realistic balance between the public and private good.

Otherwise ... we might as well start looking for our own Edward Gibbon.

Please Mind The Gap
...Ave Caesar, Morituri Te Salutant (*)

As real estate values and consumer spending drop across the US, many analysts are betting the economy will carry through based on the stockmarket's continuing positive performance. Their hopes are misplaced.

For one, rising share values are not creators of economic activity in and of themselves but mere representations of the price for assets that produce an income stream (i.e. profits and dividends). If the underlying economy is not creating enough demand for goods and services the income streams will soon diminish and so will the value of the assets. Monetizing assets through debt (i.e. taking out loans against homes or shares) can create a temporary artificial boost to growth, but only at the price of even lower growth later, when interest payments demand a higher percentage of income. The banker will have his "pound of flesh" and the debtor will do with less.

For another, a very small percentage of Americans own the vast majority of all stocks, i.e. the benefits of rising share prices are concentrated to a tiny fraction of the population. As the table below shows, the top 20% of Americans own 90.6% of all stocks, while the bottom 80% own just 9.4%. What's more, even within the top 20% there is heavy ownership at the very high end of the wealth class (the top 0.5% owns 28%).


This huge gap between the "haves" and "have nots" refutes all claims about an "ownership society": it's clearly a myth. Furthermore, it is a dangerous myth because it lulls the vast number of people into thinking all is well (and borrowing for groceries against their homes), just because some irrelevant share index is making new highs.

This is so much like Rome in the 2nd and 3rd Century AD: the plebs were content with gory spectacles in the Coliseum, the emperors and the porcine senatorial class partied on Palatine Hill and the Empire slowly crumbled all around them. I wonder, did they have a Games Index back then? I bet they did...

(*) Hail Caesar, those about to die salute you.

Retail Sales Softening

Just a couple of charts on today's release of retail sales.

The first one is the change in sales from the same month last year (in dollars). For example, in April 2007 there were $11.4 billion more in sales than April 2006. All data is adjusted to reflect seasonal and trading day changes.

Change in retail sales from prior year - click to enlarge

The next chart shows the same Y-O-Y change, but in percentage terms.

Percent change in retail sales from prior year - click to enlarge

Consumer spending is 70% of GDP and about half of that comes in the form of retail sales, so the weakening pattern is clearly pointing to a soft economy.

Send In The Meds

As I wrote in another posting, I am always on the lookout for excess - be it on the upside or the downside. I define excess as the extreme overshoot of speculator exuberance above what is warranted by fundamentals (and vice versa for the downside).

China's stock market is my current case in point: I have been looking at it for several months, but an article in the NYT titled "Share Prices in China Hit Record High" got my antennae buzzing as it summarized all indicators of excess in just a few sentences. Share speculation in China has left the sphere of mere bubble-ness and has become one of history's rare occurrences: a bona fide mania.

Shenzhen A Index

...The Shenzhen A Index is up 100% this year, in just over 4 months; it was up another 100% last year, for a total of 300% in 16 months.

...People are waiting in long lines outside banks and brokerages to open new accounts.

...College students are taking loans and homeowners sell their apartments to buy hot stocks.

...Listed companies are raising money from the stock market and plow it back by buying stocks.

These signs point to lack of market experience by the vast number of new speculators, a shallow and opaque market and a regulatory bureaucracy that apparently does not have the knowledge and experience to cool the runaway market. It has now become too late to save the hapless maniacs from injuring themselves.

The lunatics have taken over the asylum: being off their meds, they are convinced they can soar like cranes, China's beloved bird of myth and longevity. Shrieking with delight and glee they are running up the stairs to the roof, from which they will ultimately launch themselves onto the pure, thin air. They will smile contently as they spread their wings out to flap in furious, yet graceful, strokes seeking to capture the ether and soar to the boundless azure sky.

The doctors will soon realize that they have to send in the white-clad muscled orderlies to force-feed proper meds to the loonies, before they all end up in a pile outside the asylum. To wit: expect a yuan revaluation, an interest rate hike or another move up in bank reserve requirements - or, more likely, any combination thereof.

If you have any doubt as to how such manias end, I provide a chart of the sudden rise and grinding fall of another, lesser known, stock mania that gripped the naive Greek public in 1999. Notice the similarities: up 160% in one year, then a leap of another 45% within just a few weeks for a total of 270%. All the manic elements visible in China today were also apparent all over Greece: hundreds of thousands of new accounts opened in a few months, farmers and shepherds selling their land and flocks to buy stocks, a sense of triumphal entitlement to becoming rich within days. The resulting drop took longer, but went all the way back and even lower.

They should have kept their sheep.

Athens SE, General Index

Oh, and in case you did not know: The most rabid gamblers in the world are Chinese, closely followed by the Greeks. Ask any casino or sports- betting executive.

The Negative Effects Of A Negative Saving Rate
..and The 19th Century Sick Man of Europe

For the past 24 months in a row Americans have been spending more than their disposable income, resulting in negative saving. Personal saving in current dollars peaked in 1992 at $362 billion/yr and is now running at a negative -$102 billion/yr.

What does this mean, in practical terms?

Spending above the rate of disposable income growth must - by definition - be funded through selling assets and/or added borrowing. This means that, on average, someone other than Americans must provide the extra money to buy the assets and/or fund the increased debt service. The result can be clearly seen in the rapidly rising amount of US securities held by foreigners. Of the 2006 total $7.8 trillion, approx. 70% was debt and 30% equities.

US Treasury TIC Reports

Another interesting aspect is who has been buying all those American securities, particularly US Government debt. Between June 2006 and February 2007, foreign ownership of US Treasurys increased by $163.6 billion reaching a total of $2.141 trillion. Of that increase, 39% came from the UK, 32% from China (incl. HK), 17% from Brazil, 4.5% from Canada, 4% from India and 3.5% from Turkey.

That's a very interesting change: countries formerly known as "third world" or "developing" are now increasingly funding the US consumer, instead of the other way around. The "normal" course of mercantilist events is for an economically powerful country ABC to lend money to the weaker XYZ, so that XYZ's consumers can buy imported goods manufactured by ABC, which thus profits from both its industrial and financial capital bases. This was the British Empire model and the US copied it very successfully after WWII, despite all the Cold War issues that frequently disguised mercantilism as ideology.

The tables are now turned and the US is increasingly dependent on "the kindness of strangers" to maintain its living standards. Surely, not a sign of economic prowess. Indeed, the current situation reminds me somewhat of the late-19th century Ottoman Empire, known then as "the sick man of Europe". Despite its former glory and power, it got caught between a number of costly wars and a weak, corrupt domestic fiscal system (low tax receipts vs. expenses) and became highly dependent on foreign loans. Vast fortunes were made by some very sharp bank operators in Istanbul, Paris, London, Vienna and Berlin who bought Ottoman bills and bonds at deep wholesale discounts and retailed them to investors and speculators throughout Europe.

This is not unlike the current securitization scheme: domestic loans of highly dubious quality are sliced and packaged into "retail-ready" bonds, resulting in huge mark-ups and fees for today's sharp operators, foreign and domestic. Plus ca change, plus c'est la meme chose...but I sincerely hope for everyone's sake that the US debt does not end up as fancy wallpaper or framed reminders of investment folly.

Real Estate Bubble: Another Metric

I live in a major Metro area and my favorite Sunday newspaper has the Classified Ads section as a separate insert. This week it came in at a weighty 128 pages (not only did it look like a record, it felt like one, too) of which 115 pages (89.8%) were "Real Estate For Sale" and a mere 7 pages (5.5%) were "Real Estate For Rent".

In gross numbers, around 10,300 ads were "For Sale" and just 630 "For Rent", for a ratio of 16.4-to-1. I don't follow the ratio over time, but it seems to be at a record, too, just by my eye-balling the RE section from week to week.

I don't care what economists, analysts, politicians, bankers (central and otherwise) say: Anyone can see and feel that this market is in deep, deep trouble: all one has to do is buy the Sunday paper. It's not even necessary to read it - in fact, this usually confuses the issue further. Just count the pages...

Further On CDS...

In response to a previous posting on CDS creating liquidity/debt, a CDS trader (known simply as "the cds trader") was kind enough to leave the following comment on 4/29, which I have just noticed. I am reproducing it and give my response below:

The CDS Trader said:

"notional amount of CDS is over-hyped from those without proper knowledge of this market.

the "liquidity" in this market merely allows efficient transfer of risk, hopefully to those able to bear those risks (although I'm sure plenty of counterparty's are not in that position!). it doesn't exactly mean debt creation. if the SP500 had 2bn contracts traded daily instead of 1bn (i don't know what the exact numbers are), you wouldn't say that companies can issue equity any cheaper? in the same way, it is the wrong argument for credit derivatives.

and as for the market value of CDS contracts...how can it be anything other than zero net-net? each trade is a contract between 2 counterparties (c/p), and so one c/p will be down the same amount that the other is up.

the growth in CDS is the most over-hyped point from the conspiracy theorists. and trust me, I have been a CDS trader since the market was in its infancy in the 90's, AND i am incredibly bearish on global liquidity/asset values. think you should be looking elsewhere for negatives though."

My response:

a) High secondary and derivative market liquidity in ANY instrument allows its primary market to expand- that's the whole idea! I have been personally involved in setting up and operating secondary and derivative debt markets from scratch and I can testify that the subsequent development of the primary market involved was very fast, indeed. The increased secondary/derivative market liquidity and transparency drew in the major global players, in turn allowing the primary market to expand in size and pricing. It DOES get cheaper to issue stocks, bonds, whatever, if the secondary/derivative market is active and deep. The problems begin to arise when the process goes too far and the tail (derivatives) starts to wag the dog (cash mkt.).

b) Net-net everything cancels out: one person's asset may be another's liability - that's not the issue here (though it took humans millennia to invent and apply the double-entry accounting system, so it's no as self-evident as it appears). I was referring to the creation of income streams (CDS premia) and potential default exposure in vast excess of the original bond issuers' obligations. As you know, there are many more CDS's outstanding (notional) on individual issuers than their underlying bond obligations. This process does not merely transfer risk, it creates excess risk. Just because that excess risk is then netted out between counterparties (of dubious ability to withstand it, as you mentioned) does not mean net systemic risk is zero.

c) I sincerely hope I do not sound like a conspiracy theorist! And I know for a fact that Buffett ("instruments of financial mass destruction") isn't one either; maybe he is getting too set in his ways and conservative in his old age, but I seriously doubt it.

d) The rise of the CDS market is not the sole creator of potential trouble in this over-indebted and asset-inflated world. Indeed, CDS's are a symptom of high debt, not its cause. With all this liquidity (i.e. debt) floating about, a way HAD to be found to shift credit risk around and make it more bearable by the economy as a whole. It's just that, in my opinion, the process has gone so far now as to pose added systemic risks, as I pointed out above.

In closing, I thank "the cds trader" for his/her valuable input and invite further comments.

Sarkozy v. Gasoline

What does the election of Nicolas Sarkozy as President of France and the record high price of gasoline at US pumps ($3.07/gal) have in common? Directly, nothing... but digging a little deeper, they are both manifestations of the same problem: there are too many of us humans on this planet and our growing consumption is straining national, social and natural boundaries.

Sarkozy got elected - in large measure - because of his anti-immigration policy, i.e. shutting the doors of France to large numbers of poor North African economic immigrants and deporting all those already in France illegally back to their countries. He is also completely against the entry of Turkey into the EU. Some may think him racist, but it is probably just his way of preserving the wealth and comfortable lifestyles of the French from the masses of poor foreigners straining against the walls of Europe.

And it is not just France: the US is also involved in a thorny immigration issue, the "Polish plumber" is raising competitive fears within the EU itself and hundreds of thousands of Iraqis have already abandoned their country. In fact, Iraqi medical schools have been ordered to stop issuing paper diplomas and transcripts in an effort to stop their graduates from fleeing to practice abroad. Everyone wants a better lifestyle - who can blame them? Globalization may have allowed for cheap Chinese imports, but it also raised everyone's awareness of the wide divide between rich and poor. When your neighbour is eating prime rib and you are starving, those leftovers look mighty inviting.

Now, if the election of Sarkozy points to mounting social pressures, record prices for gasoline are a sure sign of resource demand reaching supply limits. I do not know if those limits are "hard" (i.e. constrained by nature) or "soft" (i.e. added supply will soon kick in), but price action is not reassuring: Since 2002-03 the price of copper has increased 5x, nickel 6x and aluminum 2x. Corn, soybeans, wheat and oats have doubled and even rice has gone up by 150%. Hog prices are also up 150% from their lows and feeder cattle 60%.

If it weren't for all those cheap goods from China flooding western markets and offsetting rising material input prices with cheap manufacturing labor, even officially calculated headline inflation indexes would be zooming by now. Things get further complicated when we consider that the cheapness of chinese imports is dependent on the yuan being pegged against the US dollar. Right now, a factory in Guangzhou is effectively using the same currency as a factory in Ohio, only with 1/50th the labor cost plus next to zero environmental, safety and health regulation costs. In other words, those cheap prices we all enjoy so much during our trips to the mall - be it in Peoria or Poitiers - are hanging by a very thin thread, indeed: the thread of a currency peg. If it snaps, we may be left with an emasculated manufacturing base in the US (and increasingly, in Europe, too) and rapidly rising import prices. It's no wonder that Hank Paulson, the US Treasury Secretary, is constantly flying back and forth to China.

One final anecdote: Yesterday I had lunch with a friend who imports and trades chinese goods and I asked him what would be the effect to his business of a 7-8% rise in prices from a potential yuan revaluation. None, was his answer, explaining that there is simply no one left domestically that makes any of the stuff he imports. Left unsaid, but fully understood, was that his domestic prices would simply go up by the same percentage and the consumer would have to pay them, want it or not.

Margin Debt and S&P

A chart pair for Sunday...

The NYSE reported that margin debt reached $293 billion at the end of March 2007, a tad below the all time high of $295 billion reached the month before. Since the cycle low of 1974, margin debt has increased a whopping 74 times, for an average compound annual rate of 14.1%.

US Margin Debt, Log Scale

In the same time S&P 500 has gone up 25 times, for a compound annual 10.4%.

S&P 500, Log Scale

One more observation: It is certain that margin debt reported by NYSE no longer provides an accurate picture of stockmarket leverage. Financial derivatives that create huge gearing are now so prevalent that the Fed's 50% margin rule (Reg. T) is essentially a dead letter.

Oh, and something else: it was reported in the latest BLS employment data that 14.400 jobs were lost during April from the "credit intermediation and related activities" financial sector. That's the biggest one month drop since such data started being collected in 1990. If I understand it properly, this is were all those mortgage broker jobs reside.

Credit Intermediation Jobs - Change from month before

The Era of Trillions: Success Through Excess

Not a day goes by without the announcement of several multi-billion dollar takeover bids. The "feel" of the market is remarkably similar to the late 1980's - early 90's when swashbuckling takeover artists like Ivan Boesky, KKR, Carl Icahn, T. Boone Pickens and many others were empowered by seemingly unlimited junk bond funding from Mike Milken's Drexel Burnham Lambert. At first the bonds were sold to institutions, but eventually the deals got so large and fluffy they had to tap that perennial sucker, the retail investor. Stuff like 12% RJR junior notes to finance the takeover by KKR was aggressively promoted via the retail network of major brokerage firms, with 3 point commissions attached. That's a lot of scratch, for bond peddling...

That era of excess did not end well and several protagonists did time behind bars - even if only at Camp Fed and only for a short while. However, the final bill for the Predators' Ball had to be borne by the taxpayer through the Resolution Trust Corporation, the largest ever financial bailout arrangement (~$50 billion). Greed was not good, after all.

Which brings us to the present era of easy money, the Era of Trillions. Carl is still around and so is T. Boone, but they are hoi polloi compared to the younger hedge and private equity barons. This crop of financiers have learned a thing or two from the past and mostly keep a low public profile, though their annual compensation is upwards of a billion dollars. But the excess is there, just as it was 20 years ago and the retail investors are being tapped, yet again - this time through their pension funds.

Hedge fund assets are now $1.6 trillion and through leverage their open market positions are certainly twice or three times that. No one really knows how much total money is involved at private equity funds, but it is definitely more than hedge funds: in 2006 alone private equity firms raised $430 billion in new money. The "billion" is dead, long live the "trillion". Just for comparison, US GDP is $13.4 trillion and global GDP is ~$50 trillion.

Let's compare: in the late 80's corporate raiders at least used the fig leaf of consolidation, of getting rid of corporate "fat", to justify their actions. Today's private equity firms don't even bother with that: they buy entire companies with the expectation they will sell them to someone else at a higher price, just because the market will go up. The ultimate in no-value-added hubris: We shall make money because it's us. These guys have gone beyond greed, they believe themselves omnipotent - if money goes to your head, then extreme money surely goes to your psyche.

Euripides lived 2.500 years ago and had no clue of "modern" finance. But he certainly knew human folly was timeless, when he wrote: "Whom the gods wish to destroy, they first make mad."

Posting On Comments

After my May Day request, some readers suggested that I comment on: a) value investing, b) the soundness of ETF sponsors and c) "where it is all going". Let me first thank you for taking the time to make these suggestions - please keep them coming.

Value investing

Made popular by such luminaries as Graham, Buffett, Templeton, Neff and others, it is a time-tested approach. However, it is not at all easy to identify "value"; apart from mechanical low p/e and p/bv approaches, it requires much slogging through financials, the understanding of the business involved and at least some sense of timing. One must also be very careful to distinguish between what may appear as "value" vs. a fundamental, permanent change in the economic worth of the enterprise due to a shift in technology, consumer tastes, etc. (eg buggy whips vs. steering wheels). In other words, a company's price may be low because its business is in permanent decline. Also, with powerful information technology now at everyone's fingertips, finding real diamonds in the rough has become extremely difficult.

Probably the best way to identify value is through your own daily experience. Keep your antennae up and try to find companies or sectors you are familiar with that are coming up with new or better products and services. My best personal example is of a friend who was a telecoms engineer years ago - he saw that a small, little-known company had come up with a very good product that his own company was buying in big numbers. So he bought shares in it. The small company was CISCO and the year was 1992.

Apart from the above, my other approach is to try to fathom fundamental macro shifts in the economy, identify the sectors that will benefit or suffer, find and analyze the appropriate sector leaders and invest accordingly (long or short). This is more of a cyclical approach to value, one that tries to take advantage of the ups and downs in the value perceptions of the investing public. For example, right now I believe the financial sector is overvalued, from a macro perspective.

ETF Sponsors

I must confess I am not crazy about ETF's and all other types of "packaged" or "indexed" products. They promote a passive style of investment I find personally not to my liking. Oh, they certainly have their uses in cases where individual share picking may be difficult or even impossible (eg country funds), but I prefer a more hands-on approach.

But the question was about the funds' sponsors... As long as they are large, reputable firms I don't really see much of a problem, unless there is a major blow-up. Naturally, one must always be wary of the annual fees and charges involved - they can be quite sizeable.

It's The End Of The World As We Know It (??)

A reader suggested that my comments frequently reach the edge of the precipice, but never go over it to proclaim the coming of a major financial crisis or meltdown. This is because I combine a data-driven economic analysis ("just the facts, ma'm") with a search for signs of psychological/emotional excess in markets ("fear and greed"). In the rare cases where both match, I look deeper and then act. For example, the copper madness of several months ago: prices had zoomed out of control but housing in the US was fast slowing down and people were getting electrocuted trying to steal high-voltage transmission wires: fundamental data plus people's folly pointed to shorting copper.

Right now the financial system in the US shows both kinds of negative signals: the economic data is coming in weak-ish and there is a party going on in Wall Street, albeit low-intensity (the drunken revelry is in Shanghai). But the individual investor is laying low in the US and Europe, having left the field to hedge and private equity funds who are maintaining the party through steady infusions of borrowed cash. They have a massive vested interest in keeping the party going, so it is difficult to say WHEN the party will be over and - most crucially - HOW it will end.

Usually, "smart" money takes a market to within 75-80% of the ultimate top and then unloads to the unsuspecting multitudes by creating a get-rich-quick euphoria that gooses the market the rest of the way. They typically unload after the crest, too, when individuals see the weakness as a "buying opportunity" and foolishly "double-down". We have not seen any of this yet in the US and Europe (though I strongly believe it is unfolding in China). What's more, I suspect we may not see this scenario play out in this market cycle: this time it may become a game just for the big boys, something straight out of the 19th century Gilded Age clashes between Morgan, Vanderbilt, "Diamond Jim" Burke, Jay Gould, et al. Certainly, the socio-economic climate is similar: monstrous gains for a few hundred "financiers" (some are making over a billion dollars a year) while the public is in huge debt, stockmarket takeover clashes are producing enormous bids, asset wealth is swamping income generation and so much more...

During the Gilded Age we got regular economic and market "panics" even though the public had very little participation in the bond and stock markets. They culminated in the Great Panic of 1893, which was the most serious to that point, with bank failures and very high unemployment.

So, in answer to your question, I suspect the current cycle will end with a 19th century-style panic after the "smartest" operators unload their paper on the "smart" ones. After all, there are now tens of thousands of hedge funds, private equity funds, asset managers, etc - and they can't ALL be "smartest". I bet 90% of them will end up holding the bag.

ADDENDUM: Of course, the wider public is already in this market through their pension funds - 30% of all investments in hedge funds are currently held by pension funds. That's 30% of $1.6 trillion, so we're talking serious money here. Individuals are in it, allright, they just don't know it.

Factory Orders

Once again, economic data was announced in such a way as to produce maximum cheer from the peanut gallery. Factory orders up 3.1% in March vs. February, when the "consensus" expectation was 2.0%. Riiiight... Of course, we had gotten an advance indication last week from the durable goods orders (also up "more" than expected), so the total manufactured goods number should have surprise no one.

Instead, look at the year-over-year comparisons for factory orders...Around August 2006 their rate of increase plunged and has been negative for every month so far in 2007 (Jan-Mar), i.e. fewer orders than the same time last year. This is in current dollars, too, so real figures are much worse.

The "60 E-Z Payments" Hint

Back from my May Day "strike" (and, hopefully, my writer's block) and there were several suggestions to my request for topics to discuss - I will take them up tomorrow. Today, I will deal with a subject that has been nagging at me for several weeks, after I visited a housewares store and to my amazement noticed that it had put items as cheap as $15-30 on the E-Z-Payment Plan: a buyer can make 60 monthly payments for such things as curling irons, no-stick pans, and ironing boards - at an added interest cost, of course. Imagine that! The payment obligation, low as it may be, is almost certain to outlast the useful life of the item. Not only that, but the way they do it is they charge the payments to a credit card every month. Unless the buyer pays the card bill in full every month, he/she incurs and compounds double interest charges. The cheap-o item will end up costing a bundle after 5 years. That's what I call maximum effect consumer finance...

After being shocked at the venal banality of merchants and banks (in for a pound, in for a penny...) my mind leapt to the those weird tangents it usually does and so I eventually came up with today's posting. Here's the conclusion, right up front:

We are going through the very zenith of free-market capitalism - what will follow won't be pretty unless we do something right quick.

The free-market system is based on ever growing consumption regulated by the triangular relationship between Supply-Demand-Price: we may fix up to two of those variables, but never all three. So, what happens if the supply of essential goods goes into permanent decline? I define permanent decline as the condition where no matter how much you pay for a good, its total supply never increases but keeps inexorably decreasing with time. One common example is Peak Oil, but we may also think of food, metals, clean air and water, habitable land with temperate climatic conditions, etc.

It is obvious, to me at least, that orthodox free-market economics would go completely out of the window, since higher price signals simply won't create more supply. Out will also go fiat currency monetary policy, the basics of debt finance, pension accounting and a host of other modern-era economic principles we currently take for granted. Without preventive, enlightened intervention we may end up with a stagnant, command socio-economic system, something I call "medieval economics".

Naturally, I am not the only one thinking along those lines. Dozens of economists and thinkers have previously grappled with this idea (e.g. "The Limits to Growth", from the Club of Rome in 1972). You may also know that, as recently as the late 19th-early 20th centuries, the correlation between "growth" and "stability" was inverted, as could be seen in the relationship between stocks (growth) and bonds (stability). Price/earnings ratios were then extremely low (5-6x), whilst interest rates were tiny: stability and certainty of income were prized above all - not because people were "risk averse", but simply because there was little "growth" to be had by investing in company shares.

You may ask, "what does 60 E-Z payments for frying pans have to do with permanent supply declines?" As I said, my mind goes on tangents so I will try to explain my mental leapfrogs... If it takes a 60-month double loan for people to buy a cheap $20 item, then cash on hand is in short supply. Unencumbered cash (i.e. not from borrowing) is an excellent measurement of how much can be consumed right here, right now. Therefore, the current Price/Supply relationship for goods is such that Demand can only be covered by borrowing at ridiculous 60- month terms. And if that holds for frying pans, it also points to supply problems for more day-to-day, essential goods.

What can replace our free-market economics, if not a medieval throw-back? If we are smart, we should be thinking of regulated consumption and social cohesion, the very antithesis of the unrestrained free-market individualism that is in apotheosis right now.

After all, those $20 frying pans are made possible to us (even if with 60 payments) because the other 2/3's of the people on this planet can't yet buy them at all, but are willing to make them at a meager wage for export AND to provide the financing from their savings. What happens when this willingness goes the other way?

I see those 60 payments as a hint that the direction is starting to change and that we should be looking for a new socio-economic and political model. Does anyone else see it that way? When I asked the cashier at the store what she thought about this new 5-year financing for cheap merchandise, she shrugged and said: "It's a good thing, because people don't have much money these days". I doubt she thought through what she said...

On Strike

This is May 1st, Labor Day in most of the civilized word. It is an established holiday, but by tradition it is called a general strike - So, I'm on strike too. Well, to be perfectly honest, I have also smacked on that proverbial writer's block wall, so international labor solidarity is a perfectly adequate excuse to take the day off.

But don't let that stop anyone of you from suggesting topics, articles and factoids in the comment section below.

Bloggers of the world, unite!