Tuesday, November 8, 2011

European Science Fiction

John Adams once said that “all the perplexities, confusion, and distress in America arise, not from defects in their Constitution or Confederation, not from want of honor or virtue, so much as from the downright ignorance of the nature of coin, credit, and circulation.”  He could well have been referring to modern day Europe, as the widespread misunderstanding of the nature of international capital flows has been a consistent theme throughout the Euro crisis.

Europeans are certainly perplexed, confused, and distressed over the deteriorating economic situation.  Unemployment is 18% in Greece and 23% in Spain, and far worse among youths.  Household savings in the Euro area are 14% and business investment is falling.  On top of this, countries continue to implement painful austerity measures, driving themselves even farther into slow growth or recession and paradoxically worsening their fiscal situation in a downward spiral.  Some skeptics have blamed political dysfunction in the Eurozone by pointing to the ineffective Lisbon and Maastricht treaties.  Others have blamed “honor” and “virtue”, spreading the myth that the crisis has arisen from profligacy on the part of the southern European countries.  Few commentators or decision makers seem to understand that the heart of the issue lies with the nature of money itself.

Money is associated primarily with two uses: as a medium of exchange and as a store of value.  These two features are complimentary and reinforcing.  As an economy grows, money circulates around, creating value with each transaction.  Some people save money and others borrow, allowing resources to be deployed efficiently over the business cycle.   However problems arise when financial bubbles burst, contracts are breached, and those who have saved become concerned about getting their value back.  In this situation, money’s value as a medium of exchange goes down and there is a large incentive to hoard rather than lend.  However when everyone tries to save at one time, economic activity cannot take place and savings are destroyed, leading to more fear and hoarding in a self-fulfilling downward spiral.  This cycle perpetuates itself until something breaks it.

In modern economies, central banks play an important role in promoting financial stability as a lender of last resort to key systemic financial entities.  In fact, central banking began in the UK in the early 1800s during the collapse of the British canal boom.  Even though the bank did not have legal authority to lend and purchase assets to get credit moving, it did so anyway to prevent a devastating economic contraction and systemic meltdown.

Today European leaders are avoiding this approach because they do not understand the circular stock and flow dynamics of money and are extremely fearful of anything sounding like inflation or bailouts.  For this reason they have shackled the European Central Bank from performing its most important role.  Instead they persist in ideology-driven temporary solutions to the crisis that seem designed simply to delay the day of reckoning rather than face what needs to be done.  Albert Einstein said that insanity is doing the same thing over and over again and expecting different results each time.  The continual calls for austerity which has clearly devastated the Euro Zone region would fit in that category.

The acronym EFSF refers to the European Financial Stability Fund, which was set up to serve as a lender of last resort in place of the European Central Bank.  A similar acronym ESFS refers to the European Science Fiction Society.  The financial markets are realizing that without the backing of a central bank, the EFSF may be something of a science fiction story as well.

Thursday, October 6, 2011

China’s Next “Great Wall”

In his book The Beijing Consensus, Stefan Halper describes China as similar to an elephant in a room full of blind men trying to figure out what they are dealing with. One of these blind men comes in contact with the tusks, and believes he has encountered several spears that are sharp and sturdy. The next man feels the ear and thinks the elephant is a leafy plant. The others feel the tail, hide, leg, and trunk and thing they may have found a whip, wall, log, and snake respectively.  Each blind man understands only a piece of the overall picture without getting a true sense of what the elephant is and how it works. Paradoxically, their attempts to communicate with one another only serve to confuse them even further about the true picture.

Many investors note widely acknowledged strengths of China’s economy according to a few highly visible metrics. Some look at China’s clockwork double-digit GDP growth numbers for 30 years, others look at its massive population of 1.1 billion, and still others note the strength of its manufacturing sector, which is now slightly larger than the US, which held the lead for 104 years (both countries account for about 20% of manufacturing output each).  In fact, a Gallup poll conducted in February 2011 showed that more than half (52%) of Americans believe that China is the leading world Economy, compared with only 32% who chose the US (in reality the US economy is close to three times as large as China’s).

One aspect of China that is only now becoming clear is the extent to which its miraculous growth trajectory has been dependent on exports and construction activity and the difficulties China may face in transitioning to a more mature consumption-driven economy.

The central government of China targets an annual rate of 8-10% growth in production and employment, and incentivizes local government officials to meet that target. If the economy falls short in a particular year, local governments often borrow to fund property construction projects to make up the difference and reach their targets. This has resulted in the phenomenon of Chinese “ghost cities” such as Ordos, Tianjin, Zhengzhou, Chenggong, and Kangbashi to name just a few.

A consequence of this approach is that a very large portion of China’s GDP is devoted to construction, to the point where there is little room for spending on other things.  Only about 30% of China’s economy is based on consumption, compared to about 70% for the US and 60% for Brazil. Close to two thirds of Chinas production is in fixed asset investment, which is unprecedented for any country in history. This phenomenon helps explain why China accounts for only about 8% of world production but consumes close to half of many of the world’s base metal commodities.

China’s construction activity accelerated in 2009 as the world economy slowed and China unleashed a massive stimulus campaign funded primarily by local government borrowing through financing vehicles and heavily focused on construction. This had the effect of keeping economic growth rates high, but it also resulted in huge amounts of loans to local government building projects on the books of the Chinese state-run banks. As many of these loans will mature in the next couple of years, it is beginning to appear as though the cash flows will not be there to support all of them and China may face a “Great Wall” of non-performing loans as it experienced about a decade ago after a long similar construction boom period.

China will undoubtedly be a source of economic growth and rising geopolitical influence over the coming years and decades. However, before diving into exciting growth stories, investors should make an effort to understand the underlying structural difficulties that emerging economies often struggle with while transitioning to developed status and whether the valuations of the stocks in those countries make sense given the risks involved.

Monday, October 3, 2011

The Euro Crisis

There are a number of stories out there concerning the Eurozone crisis. The most popular ones for the purposes of grabbing headlines seem to be those that characterize this as a “debt crisis” brought about by profligate government spending on the part of the periphery European countries, most notably Greece, Spain, Italy, Ireland, and Portugal. Because of this view, the most powerful countries in the Eurozone (France and German) have driven policy mandates to slash spending in the offending economies. This is a moralistic political response rather than one based on facts and economic theory.

The central  problem the Eurozone is dealing with is one of relative competitiveness due to monetary inflexibility rather than overspending. The graph below shows fiscal balances (government spending) and current account balances (net exports) in the time period leading up to the crisis.  



Note that Germany and Austria had some of the largest government deficits, while Ireland and Spain actually ran budget surpluses. Furthermore, the Eurozone as a whole has less debt relative to its economic output than either the US or Japan. The countries with problems are the ones who ran trade deficits, not budget deficits. This shows the divergent competitiveness brought about by structural deficiencies of the Euro monetary union. The trade deficits in the PIIGS countries were matched by capital inflows, and when those reversed in the crisis the system came under severe strain.  

This idea of a “Euro crisis” as opposed to a “debt crisis” can also be seen in the prices investors pay to insure various sovereign credits, most directly in the pricing of contracts called “Credit Default Swaps” or CDS, which make bondholders whole in the event of a default.  



While France and Germany both have AAA ratings and the US was recently downgraded to AA, CDS rates have gone up dramatically for French and German debt while remaining constant  for US Treasuries. Bond investors clearly understand that debt is not the problem; in fact, the structure of the Euro is the problem. This cycle has been repeated many times in history. It is the reason countries have left the gold standard, and it is the reason many Latin American countries un-pegged their currencies from the US Dollar in the 1990s.  Capital flows can be highly unpredictable and damaging to economies, and governments that do not control their currencies are often subject to speculative attacks. The Eurozone crisis provides clear evidence of this.

Thursday, September 8, 2011

Who’s the "Patsy" in the Gold Trade?

In financial markets there is a seller for every buyer, so when trading any security you should keep in mind what knowledge you believe yourself to have that makes your side of the trade the best one to be on.  Warren Buffet illustrated this idea with the quote:  “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy." After a 12 year run, an ounce of gold is worth close to $1,900, implying that all the gold in the world together is worth about $6 trillion, or about 1/7 the value of every publically floated stock combined. Gold buyers would be wise to look around the table at fellow speculators and ask the question “who is the patsy?” this time.

Investors unfortunately tend to follow a herd-like behavior of chasing returns and buying whatever has gone up the most in recent history, a phenomenon which often causes boom/bust cycles where aggregate wealth is destroyed and the average investor gets burned from piling into the investment last. Consider the era of the late 1990′s when “DOW 36,000″ and the “Great Moderation” were the widely accepted paradigm with dot com stocks leading the way, and the late 2000′s when the belief that “real estate prices always go up” brought the global financial system to the brink of collapse. These are just the most recent examples of a series of bubbles throughout human history, and we have seen the latest bubble formed in supposedly “safe haven” assets, most notably gold.

Money has poured into gold-related securities as a variety of narratives of gloom and destruction have permeated the media and our daily lives. The prevailing story is that gold is the antidote to concerns of hyperinflation, currency debasement, slow economies, and manipulated markets. In contrast, the historical reality  is that gold has not performed well in periods of inflation, periods of crisis, or periods of "money printing". In the 1980s gold lost 84% of its value despite high inflation, in 2008 gold fell 30% during the financial crisis, and over the past 200 years gold has returned  just 0.5% annually (with large losses in many periods) after inflation compared to 7% annual returns in the stock market and 3.5% in the bond market despite widespread use of fiat (printed) money. In the short run this reality does not matter because if enough investors believe the story it necessarily becomes self-fulfilling, however in the long run there is always a reversion to the mean.

A historical parallel to the pitch for buying gold is how the method of valuing tech stocks based on eyeballs became popular in the late 1990s. Below is a quote from an academic study published in the year 2000 called "The Eyeballs Have It" by professors at the University of California Berkeley:
“Consistent with those who claim that financial statement information is of very limited use in the valuation of internet firms, we are unable to detect a significant positive association between bottom-line net income and our sample firms’ stock prices“.
The story during that time period was that the profits companies earn do not matter for their stock prices (which incidentally also "always" went up), only things like page views and unique users. However ridiculous the idea sounds today, this mantra actually worked and much of financial advisory world, media, and general public bought off on it for years… until the bubble fell apart and a huge amount of paper wealth was destroyed because there were no fundamental underpinnings of that wealth, only a self-fulfilling pitch concocted to enrich those pushing the paper used in the speculation. Ironically, in many cases the few investors who correctly bet against the bubble lost money for years before they were eventually proved correct.

Gold-based products are also included in portfolios now for “diversification”, which has become another self-fulfilling benefit. In fact the diversification benefits are illusory: the GLD fund could have just as easily been based on sea shells, tulips, or space rocks and the underlying investment would be “uncorrelated” to other asset classes. Therefore if one could find enough investors to pile into a fund purchasing these space rocks based on the belief that they will increase in price then the paper value of everyone’s portfolio would go up despite the fact that the so-called “investment” has no fundamental value, giving the appearance of  "uncorrelated" outperformance benefit. That is how a bubble works:  expectations create their own reality… until the game of musical chairs stops.

While gold bugs may feel they have been vindicated after a 12 year parabolic run, the victory dance will not last forever and gold will crash as financial bubbles have many times in history. The only question remaining is who will be left holding the bag when it does, or in other words: "who's the patsy?".

Monday, August 15, 2011

The Long and Short of the Market Correction

Economist and value investor Benjamin Graham famously said:  “In the short run, the market is a voting machine. In the long run, it is a weighing machine”. After an exceptionally volatile ride, market participants are now “voting” that the US stock market as represented by the S&P 500 is worth about 12.5% less than it was just three weeks ago. This post will attempt to put the recent market movements into some historical context and also make some observations about how such market events have ultimately turned out in the past.

The benefit of market downturns is that they remind investors that there is “no free lunch”:  returns do not come without the risk of losing some of the investment along the way. Boom and bust cycles in the financial markets have occurred throughout history and capital and wealth destruction is as common as wealth creation.

The chart below shows the current bull market as compared with others in the past 2011 years. It currently ranks slightly below average in both length and percentage gain from the trough.



Volatility like that of the past month is bad for the long-term investor in several ways. One is psychological: in general people have a strong tendency to prefer avoiding losses to acquiring gains, referred to as “loss aversion”. Some studies have suggested that the impact of losses is twice as powerful as the impact of gains from a psychological perspective. For this and other reasons, investors tend to buy at the top and sell at the bottom as the pain of losing money in the short term quickly overwhelms their desire to grow it in the long term. A recent academic paper by Cass Business School examined the time period between 1992 and 2009 and determined that poor market timing by investors resulted in a loss of about 20% total or 1.2% per year.

Another reason volatility hurts long term returns is that negative returns are simply worse mathematically. If an investment declines by 50%, it takes a 100% subsequent return just to get back to even. From the year 1982 to 2000 the S&P 500 returned 666% total in cumulative inflation-adjusted gains, but the bear market that ended in March 2009 wiped out 60% of those gains from the peak. The all-time high has still not been recovered and may not be for years.

While what comes next for the stock market is anyone’s guess, recent economic indicators show that the US market correction may have been driven by a swift change in sentiment rather than any shift in the underlying fundamentals of the economy. Consumer sentiment plunged in August to 54.9, the lowest in thirty years and a huge drop from 63.7 in July. The decline appears to be related to the debt ceiling debate and subsequent S&P downgrade of US debt, which may have only a transitory impact similar to the “Black Monday” stock market crash in 1987 and Hurricane Katrina in 2005. Both of these events had a very large negative effect on sentiment but little influence on spending and employment. Data released last week showed that unemployment claims have dropped below the psychologically important 400k number and retail sales remain on a steady upward path after stalling out in March due to the Japanese earthquake disruption of automaker supply chains.

Note from the chart below that of the thirty market declines of more than 15% in the past seventy years about half of them occurred outside of the context of a recession and only eight occurred at the beginning of a recession or within twelve months prior to one beginning. While painful, market corrections are an inevitable and necessary feature of investing.



Although a recession is certainly not out of the question, large discretionary purchases in the US for items such as automobiles, houses, and business investments are still at very depressed levels relative to their peaks.  Given this, a cyclical decline is unlikely to occur simply because the most cyclical components of the economy are already weak. The slope of the Treasury yield curve has predicted the onset of recessions essentially every time over the past four decades with only a few false positive alarms, and it currently indicates a 0% probability of recession.

Households have deleveraged to the point where the debt service payment ratio as a percentage of disposable household income is at its lowest since 1992, while non-bank corporations have $1.9 trillion of cash on their balance sheets – a level that is twice the average amount kept free for capital expenditures over the past 40 years. Despite the political rhetoric going into an election year, US government debt is lower than it was in the 1940s, low compared to other developed countries now and throughout history, and widely regarded by the rest of the world as the safest investment available due to the status of the dollar as a fiat currency and the strength and depth of the US economy, financial markets, and regulatory environment.

All of the talk about a “double-dip” is very common in the early stages of every economic recovery, yet a true “double-dip recession” has only occurred once in the US since the Great Depression. The economy lapsed into two back-to-back recessions during the early 1980s when Federal Reserve chairman Paul Volcker kept interest rates extraordinarily high to tame persistent double-digit inflation. While the economic recovery in the US continues to be slower than desired, those calling for a certain collapse in growth are arguing that things are “different this time”.