January 23, 2012

Where's The Press on This News?"

Marty Chenard at StockTiming.com made the following observation this morning: 

“Conspicuously missing is the banter from the press about Greece.   Bond holder negotiations stalled yesterday.  Bond Holders wanted just over a 4% interest rate.   The deal that was being dumped on them was just over a 65% loss on the face vale of the current bonds. 

Germany wanted the banks to take a very small haircut on these negotiations because many banks would become insolvent if the amount is too much due of the leverage factor used by banks.   This is a big deal, and one should wonder why the press is avoiding the topic as much as they are. 

Also a concern not being discussed much, is Greece's dependency on Iranian oil to the tune of 14% of their total oil consumption.  There was huge fear about this on Friday because if that oil was lost due to U.S. sanctions, then that would have a very negative effect on Greece's economy and its ability to meet its bond obligations.   So, what happened last night?   The European Union joined the U.S. sanctions recommendation and formally adopted an oil embargo against Iran.   Greece immediately wanted oil protections from other countries to offset the embargo actions that would injure them.  (Note: Iran is again rattling its sabre today about shutting down the Strait of Hormuz). 

Tie all that to the British profit picture, and there are plenty of problems that our media seems to be overlooking or down playing.”

Marty’s site is excellent and he issues a free daily e-mail about the stock market or certain aspects of it.  Usually, these are of a technical variety.  That’s what makes this non-technical observation all the more interesting – and relevant.  This Market STILL remains very much so, a headline-driven market and one should remain very cautious.  Whether there is anything to Marty’s observation remains to be seen and I would not dismiss it.   

January 18, 2012

The Recession of 2012

I don't know if this will come as a surprise to most people.  Most people don't have to be shown statistics to know what they can already sense from their daily observations.

Nonetheless, Dr. Lacy Hunt and Van Hoisington, get right down to brass tacks with their opening sentence: "As the U.S. economy enters 2012, the gross government debt-to-GDP ratio stands near 100%." They cite an influential 2010 historical study of high-debt-level economies around the world, by Professors Kenneth Rogoff and Carmen Reinhart, that concluded that when a country's gross government debt rises above 90% of GDP, "median growth rates fall by one percent, and average growth falls considerably more."

And that, Hunt and Hoisington note, is exactly what is happening to us: "After suffering the most serious recession since the 1930s, the U.S. has recorded an economic growth rate of only 2.4%. Subtracting 1% from this meager expansion suggests that the economy should expand no faster than 1.4% in real terms on a trend basis going forward, which is virtually identical with the economy's expansion in the past twelve months."

Bottom line, say the authors: expect recession in 2012, here and in most of the world.

This article is not as "stuffy" as you may initially think.  There is loads of good information in it and I will break some of it out in posts to follow.

January 8, 2012

The Blind Side

In the following post, James Anderson in Minyanville talks about a potential “blind side” issue.  You know, what’s not on many people’s radar right now but has the potential to be a BIG game changer.  Not surprisingly , he says that Europe and Iran will draw most of the attention in 2012, but pay attention to news of real estate turmoil in China. It could spiral well beyond the subprime crisis in the US.  I’ve mentioned China as a wildcard in a couple of recent posts and he’ll get no argument from me that this may very well be a big factor in 2012.  Here is some of his article:

“…looking beyond geophysical to geopolitical events, there are two choices. First the Iran situation gets out of hand. An attack on Iran’s nuclear facilities, perhaps initiated by Israel, and then a strong US response to any Iran provocation, especially with regards to the Strait of Hormuz certainly is possible, but it hardly is a blind side now.

My blind side pick is China.  I’ve watched the Internet and real estate booms evolve and the combination looks explosive in China.

First, China is a rapidly growing country with a prosperous upper and middle class of roughly 300 million people, just about the same size as the US. Unfortunately, they also have another billion peasants back on the farms.

Second, the original growth model for the economy was based on very cheap labor to manufacture goods for export.  I have a hard time rationalizing how you build a strong dominant global economy on the backs of peasants coming off the farms. I believe Henry Ford said, “I need to pay my employees enough so that they can afford to buy a Ford.”  To me, that was/is the definition of middle class.

Third, the new middle class in China saves a huge amount of their earnings because there is no safety net for retirement or health care in China.

Fourth, the middle class had no place to put savings but into real estate, and besides, real estate prices never drop in China.

Finally, this might be the most important: Protesting peasants still have pitchforks and torches, but they are starting to get wireless Internet.

Moving on to the scenario, there is growing evidence that real estate prices in China have peaked and are starting to rapidly decline. Patrick Chovanec, an American professor teaching at a Chinese university, writes a blog that recently has been focusing on real estate in China. This link describes how rapidly real estate is unraveling from a number of sources.

I think Chinese real estate is exactly where the US was in January 2007, except it's on steroids.  Reading The Big Short, you can see that some smart guys were figuring it out by 2005-2006, but subprime didn’t hit the financial press until early 2007 when the subprime mortgage originators, like New Century suddenly imploded.  In March 2007, Henry Paulson declared subprime was “largely contained," followed by Ben Bernanke saying in May 2007, "Subprime mortgage woes won't seriously hurt the economy." We know how that worked out.

In 2005-2006, housing companies were building new empty neighborhoods in California, Nevada, Arizona, and Florida. Chump change compared to the Chinese, whose cities built for a million people remain empty.

“If you build it they will come.” That was the definitive phrase for the baseball allegory movie, Field of Dreams. The Chinese regional governments were given GDP goals to meet, and the only way they could be met was to build it.  Well, it worked for a while, but they are not coming and buying anymore. The empty city of Ordos was the poster child for a while, but it sounds like it has spread across the country.

With respect to a real estate boom, it is different this time. Back in 2006, in the US you could get a mortgage with no money down.  All you had to do was to be able to fog a mirror. Those subprime borrowers had nothing to lose. They really were just renters. In China it is totally different.

In the Western world, especially in the past few years, gold has been viewed as a store of value. In China, the middle class had few attractive choices for investment, so concrete (i.e. apartments) was the investment of choice.  The big difference is that the new middle class has been paying cash for these investment apartments! The big losers in the US subprime fiasco were not the borrowers, but the institutions that bought the mortgage-backed nonsense that was packaged by US investment banks.  In China, the losers look to be the middle class. Millions and millions of irate people are being driven back to poverty.

How they handle this remains to be seen, but there is another interesting data point that developed last month: Wukan, a fishing village of 20,000 in southern China, fairly close to Hong Kong. Back in September 2011, the villagers of Wukan discovered that their local corrupt leaders sold farm land without informing them or providing adequate compensation.  Since they couldn’t vote their local officials out of office, they performed the only other option and ran them out of the village. The normal approach to this type of revolt would be a heavy-handed crackdown by the regional authorities, but in this case villagers cut down trees to block the roads into the village.

The villagers were armed with the proverbial pitchforks and torches, but they were also Internet-savvy.  They called in foreign journalists that had to skirt the blockade of the village but they got in.  The villagers set up a wireless Internet media center, and all of a sudden the world got to hear about the villagers’ plight.  With the foreign journalists in town, guess what happened?  A settlement, no crackdown -- at least not yet.

A potential real estate collapse with the ability of the internet to deliver a message far beyond the local confines of local protest leads me to the possible blind side. Could the suddenly wiped-out middle class, with far better communications skills and ability than the residents of Wukan, lead to civil disruptions (on the scale of Greece?) that disrupts the supply chain of Walmart (WMT), Apple (AAPL), Dell (DELL)  and countless others?

Your Apple iPad costs $499 because the assembly in China saves Apple what, $75 bucks? Less? Apple and every other manufacturer has bet there will never be supply disruption problems out of China.

This is the blind side, not to mention Apple’s. All you need is Apple to say it couldn’t hit its quarterly numbers because of supply chain problems in China. That will end the Chinese export business model. The ramifications of being unable to trust the China supply chain will move jobs back to the Western hemisphere. Some will return to the US, others to Latin America.

Will it happen? I don’t know. But if it does, there will be a resurgence in American manufacturing jobs which will only be a positive to the American economy and stock market. Of course, there is a negative side to this scenario. If the Chinese need to start selling the US Treasuries they hold, that will have a negative effect on interest rates in the US.”

Without getting too concerned with blind-side events, I still like to consider them.  Normally, I don’t put too much weight in these events though , because by their definition, their potential is small.  But I don’t think that the potential for big turmoil in China is small.  The ramifications to this are huge, also.  And throw in the added complexity of the issues with Europe not going away.  What happens if everything breaks down at the same time more or less?

It will not surprise me to see the stock market go up from here – in the short term.  By design, U.S. government officials have made it so that there are few attractive places that an investor can put their money.  U.S. Treasury Bonds? – the rates being paid are paltry (there’s a reason that PIMCO’s Bill Gross gas completely gotten out of U.S. government bonds).  Foreign securities? – they seem riskier than U.S. securities.

So U.S. securities are drawing investors solely because of the perception of a better place to go.  But I think that the money going into U.S. securities is very skittish right now – and understandably so.  Any sort of trouble is going to have investors rushing to the exits.  So I remain cautious on the Market and am almost entirely in cash.  However, I also think that we are going to be coming upon a time when the stock market will be a great place to invest.  We just need to get some events and some potential events behind us.  The time could be in months or it might take a couple of years – it’s difficult to say right now without some more data points.  

But I’ll be ready.  Will you?  Would you like some help on being prepared when that time comes?  If so, send me an e-mail or leave me a comment and let’s talk about me helping you like I have helped dozens of other individuals.

January 2, 2012

Reasons for Pessimism

As I’ve written, my view for the Market remains bearish.  There are several fundamental and technical reasons, among them:

1.    First and foremost - the international debt levels and its carry over into European banks and into the international financial system.  Nothing has been done to adequately address this issue.  Sure, there has been a lot of talks and summits, but the size of the problem is enormous.
2.    The economic slowdowns in Europe, Japan and China – and the U.S. for that matter.
3.    The TED spread (a measure of credit risk for inter-bank lending - the difference between the three-month U.S. treasury bill rate and the three-month London Interbank Offered Rate (LIBOR), which represents the rate at which banks typically lend to each other. A higher spread indicates banks perceive each other as riskier counterparties) has been at "financial crisis" levels for over a month. 
4.    The ISEE put/call ratio is a sentiment ratio and is at a level which, the last three times it was at a corresponding level, in two of the cases, was right before the mini-crash in July and the third case was in September, when the market bounced and then made a new low.
5.    AAII sentiment numbers were also released last week, and bullish investors came in slightly above the long-term average (40+%).   This is also consistent with bear market tops.
6.    The Shanghai Index is looking terrible. 
7.    The U.S. Banking Index is looking terrible.
8.    North Korea and Iran remain huge wildcards.

Can events happen which change my opinion?  Certainly!  However, I will fall back on two things that I have harped on continuously over the last few years:
  • The Market’s potential reward at this point is not sufficient for the risk right now;
  •  There will always be opportunities in the stock markets, provided one has the capital to take advantage of those opportunities when they present themselves.

January 1, 2012

2012 Initial Outlook

Given the macro-economic backdrop, it is hard to be anything but pessimistic for 2012.  The West is drowning in debt and our politicians don't have the will or the smarts to do what is right.  Is it any wonder that they are dreading the upcoming elections of 2012?  There's a reason why several viable political candidates are retiring and others are avoiding going for a "higher" office.  Their natural tendency of "kicking the can down the road" is failing. 

Total debt-to-GDP levels in the 18 core countries of the Organisation for Economic Co-operation and Development (OECD) rose from 160 percent in 1980 to 321 percent in 2010.  These numbers mean that the debt of nonfinancial corporations increased by 300 percent, the debt of governments increased by 425 percent, and the debt of private households increased by 600 percent.  The costs of the West's aging populations are hidden in the official reporting. If we included the mounting costs of providing for the elderly, the debt level of most governments would be significantly higher.

Add to this picture the fact that the financial system is running at unprecedented leverage levels and it’s apparent that the 30-year credit boom has run its course. The debt problem simply has to be addressed but we are short of political backbone.  There are four approaches to dealing with too much debt: saving and paying back, growing faster, debt restructuring and write-offs, and creating inflation.

Saving and Paying Back. For the private sector and government to reduce debt simultaneously would require running a trade surplus. So long as surplus countries (China, Japan, and Germany) pursue export-led growth, it will be impossible for debtor countries to deleverage. The lack of international cooperation to rebalance trade flows is a key reason for continued economic difficulties.  Saving and paying back cannot work for 41 percent of the world economy at the same time. The emerging markets would have to import significantly more, which is unlikely to happen.

Growing Faster. The best option for improving woeful debt-to-GDP ratios is to grow GDP fast. Historically, this has rarely been achieved, although it can be done. 

Companies can afford to invest significantly more, as they are highly profitable. The share of U.S. corporate profits in relation to U.S. GDP is at an all-time high of 13 percent, yet corporate real net investment  in capital stock in the third quarter of 2011 was back to 1975 levels.  Lost on our politicians is the fact that companies are reluctant to invest while the outlook for the world economy, taxes and new regulations is understandably high

The inability to grow out of the problem is bad news for debtors. When investors start doubting the ability of the debtor to serve its obligations, interest rates rise even further, leading to a vicious circle of austerity, lower growth, and rising interest rates.

Debt in itself makes it more difficult to grow out of debt.  Once government debt reaches 90 percent of GDP, the real rate of economic growth is reduced. This also applies to the debt of nonfinancial corporations and private households. 

[Note:  The flags represent the US, Japan, Germany, France, Britain, Portugal, Italy, Ireland, Greece, and Spain, in order.]

Assuming a combined sustainable debt level of 180 percent of GDP for private households, nonfinancial corporations, and governments, the debt overhang is estimated to be €6 trillion for the euro zone and $11 trillion for the U.S.

The target level of 180 percent can be debated but a level of 220 percent would still imply a debt restructuring of $4 trillion in the U.S. and €2.6 trillion in the euro zone.  Given the unpopularity of a “wealth trax”, this means that politicians must resort to the last option: inflation.

Inflation. In spite of today's low-interest-rate environment, interest rates are higher than economic growth rates. As risk aversion in financial markets increases and a new recession in 2012 looms large, the problem could get even worse.

So the only way to achieve higher nominal growth will be to generate higher inflation. Aggressive monetary easing has barely moved the inflation needle in the U.S. and most of Europe. Inflation is not being generated, because the expectation of inflation remains low and because there is still overcapacity and overindebtedness in the private and public sectors. Continued monetary easing will lead to a substantial monetary overhang that could, if the public loses trust in money, lead to an inflationary bubble.  Additionally, many believe that the inflation indicators do not give a true reading of the underlying rates of inflation already.  Some inflation is probably attractive to those seeking to reduce debt levels. The problem is stopping the inflation genie once it has left the bottle.

There are no easy solutions to the debt problem. At best, we expect a sustained period of low growth in the West. Even this would require the following:

-        -  A coordinated effort to rebalance global trade flows, which would require the emerging markets, Germany, and Japan to import more, thereby allowing the debtor countries to earn the funds necessary to deleverage

-         - Stabilizing the overstretched financial sector through recapitalization and slow de-risking and deleveraging

-         - Reducing excessive debt levels, ideally through an orderly restructuring or higher inflation

Current policies fall short against all these criteria. The coordinated intervention of several global central banks on November 30 could be construed as a positive sign of global cooperation, given that the whole world fears the implications of a (disorderly) breakup of the euro zone. In reality, it was once again merely a case of printing money and so did not address the one fundamental problem facing the world economy. Even China's participation reflected its worries about its biggest export market (Europe) and the risk of another  recession more than a true willingness to support the West by rebalancing trade flows. 

December's EU summit was supposed to restore confidence in the future of the euro zone.   It remains to be seen if it will even be feasible in legal terms. Even more important, it is not yet certain that the individual governments will commit to the rules as decided at the summit or that they will be followed.

Thus far, it appears that steps taken are not sufficient, because they do not address the core issues of the debt overhang and diverging competitiveness. The plan that emerged from the summit is unlikely to be enough to stabilize financial markets. With the U.K. opting out and the uncertainty about legal enforcement, there is valid reason to question the plan's credibility.  The new agreements essentially put in place some additional improvements to the existing stability and growth pact, which has not been successful to date. The politicians did not do anything of substance to address the sovereign-debt risk; there was no progress on debt mutualization through the issuance of common Eurobonds; there was no forceful monetary easing plan for the ECB; there were no tough calls made on how to address the problems of diverging competitiveness; and no strategy was articulated for reigniting growth in the euro zone. 

For some commentators, it is not a question of whether the euro zone will break up but of how and when it will break up. There is undoubtedly an increased risk of at least some (potentially disorderly) fracture in the euro zone. And some governments are rumored to be preparing just in case.
Any breakup would lead to significant turbulence in financial markets, including a worldwide recession. The OECD has warned that a breakup of the euro zone would lead to "massive wealth destruction, bankruptcies and a collapse in confidence in European integration and cooperation, leading to a deep depression in both the existing and remaining euro area countries as well as in the world economy.
As we go into 2012, it is shaping up to be a difficult year, and perhaps several difficult years. 

Many thanks to John Mauldin for much of the economic content in this post.

In later posts, I will try to come up with some concrete ideas on where to best put your investment and retirement monies to minimize exposure to what could be some nasty occurrences.  But first, I need to get more data and better understand where it looks like the major economies are headed.  For the time being, I remain almost 100% in short-term U.S. government money market funds.  Given the tendency of the stock market to trade almost exclusively on the "headlines of the day", I think that is the safest place to be right now.