Investing Pitfalls In the Year of Metal Tiger

The Year of the Metal Tiger is upon us. Traditionally, the Lunar New Year is a festive period where the Chinese celebrate by giving angpows, buy new stuff after doing a thorough spring cleaning, clear outstanding debts and look forward to bountiful rewards. However, given that the tiger is a ferocious animal, this year is generally not good for risky ventures. To succeed in investing, we will need the traits of a tiger – courage, stealth and strength.

Currently, the stock market rally has stumbled into a roadblock. Since its January high, major stock market indices have fallen about 5-8%, prompting some investors to question if a repeat of the 2008 crisis is imminent. To be sure, a typical correction of 10-15% bodes well for the stock market as it gathers strength to make new highs. The situation gets a bit worrisome when the market plunges more than 25%.

The S&P 500 is still hovering above major support at the 200-day moving average but potential time bombs could break that resilience and marks a new bear market which last for a year or more.

Sovereign Debt Defaults

The Greeks are in a tight spot after its deficit rose to 12.7% of GDP. Greece’s economy remains in bad shape – GDP fell 0.8% in the fourth quarter, continuing a 0.5% drop in the previous quarter. Its cost of capital has increased to nearly 7% for a 10-year loan. Paying exorbitant prices for loans is the last thing Greece needs when it is still trapped in a recession.

To restore confidence, Greece has promised to slash its budget deficit to 3% within 3 years but can they deliver? Working on a smaller budget is not easy when the nation is accustomed to living beyond its means and public sector demands are high. If Greece bites the bullet, economic activities will slow down, resulting in lesser jobs and smaller tax base, from which it still has to meet obligations. Civil unrest and depression are almost a certainty.

There is little room for European leaders to maneuver on the Greece fiasco (they are damned if they do and doomed if they don’t) but a quick decision is needed as uncertainty fuels more speculation. Bailing out Greece will open the floodgates and there is no going back to a fiscally responsible policy. Portugal, Italy or Spain will be asking why they have to endure austerity while the Greeks continue with their frivolous behavior?

Besides moral hazards, it is also beyond the capacity of eurozone to resolve all the PIGs debts without bringing ruin to the euro and defiling everybody’s balance sheets. Nevertheless, there are compelling reasons to do something for Greece.

Firstly, a Greece default could cause a mark-to-market of other sovereign debts and drive up the cost of insuring government bonds, depriving healthy nations of cheap loans too. We could very well see another credit crunch if the implicit backing of eurozone behind members’ finances is gone.

Next, Europe cannot shirk its responsibility of granting Greece admission when it has never complied with fiscal discipline. The previous Greek government spent recklessly and created fictitious accounts with the help of Goldman Sachs but nobody intervened. Thirdly, the cost of a bailout is relatively small compared to the trillion dollar injection of funds into financial institutions during the sub-prime crisis.

Lastly, cutting Greece off destroys the prestige and benefits that comes with a eurozone membership. If members start dropping out, the eurozone could be left with only rich nations like Germany and France. That makes the euro (at one time, billed as a reserve currency to rival US dollar) a laughing stock.

Actually, the euro has been on precarious grounds from day one, you can’t forge a monetary union without a political union. While the European Central Bank sets the monetary policy (interest rates, money supply, etc), it cannot control fiscal deficits in each nation. Politicians answer to their own electorate and fiscal discipline does not make you popular if it means lesser spending and higher taxers.

The euro is also a double-edged sword because of its inflexibility. During boom years, the low interest rates spur economic expansion but when a member runs into trouble, it cannot devalue its currency and export its way out of trouble by making products/labor more competitive.

European leaders are now setting Greece a deadline to implement new cuts and taxes as well as investigating investment banks which created elaborate schemes to conceal Greece’s burgeoning debts. It is likely that all these are just for show, Greece will make the right noises about resolving its debts and eurozone will eventually extend loans individually to Greece. Everything will be fine but don’t be tricked into thinking sovereign debts are behind us.

Greece is at best a Bear Stearns or Northern Rock in the grand scheme of things. It accounts for only 2.7% of European GDP, about the amount of US banking assets Bear Stearns had before they collapsed. Being the first guy in the spotlight is actually a blessing in disguise for Greece. The question is who will be Lehman Brothers among the debt laden nations?

Spain looks to be a good candidate. At almost 20% unemployment and 10% fiscal deficit, Spain’s problems will easily overwhelm Germany. The Spanish banks have massive amounts of overvalued real estate on their balance sheets but the government is confident of working things out. Let’s hope they do have a solution, else…

Is United States Immune To Sovereign Debts Default?

What happens to the PIGS, we could very well be talking about the United States. Whether it is Dubai or Greece, there is a limit to which a nation can snowball or rollover its debts before bond vigilantes impose themselves. By virtue of a reserve currency and being the strongest economy in the world, the bond market has been very tolerant of United States spending habits.

But make no mistake, US debts are making Treasuries investors nervous. Can United States ever or intend to repay all its $12 trillion debts? The financial crisis has taken a heavy toil on America, considering the debts piled on in the past two years alone. With federal funds rate near zero percent and buying of $1.25 trillion dollars of mortgage backed securities, toxic assets in banks are now the government’s problems. The spread between yields on 2-year Treasury notes and 30-year Treasury bonds as well as TIPS spreads (an inflationary gauge) has increased as a result of such actions.

Timothy Geithner doesn’t believe US will lose its AAA bond rating or default. He is probably kidding himself. Historically, great nations or empires crumbled when their finances went bankrupt. Geithner’s confidence will do little to inspire investors if US do nothing to reduce its budget deficit.

The situation is not expected to improve soon though. The 2009 budget deficit of $1.4 trillion (nearly 10% of GDP) was unprecedented, and over the next decade, the Obama administration has projected $9 trillion deficits. That figure will spiral upwards if additional wars, bailouts, stimulus programs, health care reforms are required.

The longer tough choices are delayed, the more difficult the solutions. Ben Bernanke has laid out his exit strategies which will have the Federal Reserve removing the props “before long.” Once we see economic growth in the U.S., there’s no reason the Fed should not increase rates, especially when inflationary pressures are building. When interest rates go up, bond prices will tank. The 10-year Treasury note could possibly yield 5-6% when the Fed takes its foot off the pedal.

To prevent another costly bailout which the US can barely afford, tighter regulations are necessary. Two years into Quantitative Easing, the troubles in US financial system are not over yet. More US banks are expected to fail as a tidal wave of commercial properties loans turn sour in 2010. In addition, the enormous stash of derivatives financial institutions carry in their inventories are akin to nuclear bombs but bankers have not learned any lesson from the financial crisis and continue the proliferation of such toxic papers.

While financial booms and busts are inherent in a capitalist market, such cycles shouldn’t bring down the entire economy. Financial markets need rules and careful monitoring so that failures are less frequent and devastating. The aim is not to curtail innovation or free will but to prevent irresponsible and reckless behavior. Obama already has an excellent adviser in Paul Volcker and it now depends whether he possess enough gumption to push through the financial reforms.

Will China crash?

Another shock to the stock market in 2010 is the potential crash in China. Chinese exports rose 21% year on year in January but fell 16.3% month on month. The vacancy rate for commercial buildings in tier 1 cities are reaching almost 50% and the overhang is a concern. Besides real estate, a lot of oversupply exists in in the steel, cement, car and shipbuidling industries which cannot be absorbed by domestic consumption alone.

Either China ramps up its exports or it follows US consumption habits by letting its citizens swipe credit cards with abandon, else slowing down production and investment is unavoidable in 2010. That will take some steam out of the economy.

Investment guru, Marc Faber, no longer believe that China can sustain the frantic pace of economic expansion. He said: “China’s economy will slow down “meaningfully” and may even be at risk of a “crash” because of the nation’s excess capacity and as loan growth slows.”

Actually, Beijing’s measures to increase bank reserves and restrict bank loans are essential to prevent overheating. Allowing the economy to become a bubble and then bursting will threaten social stability. The Chinese authorities are acting in line with the Basel Committee’s recommendations – banks should keep assets that are easy to value and wouldn’t be sold at fire-sale prices in times of stress. Lenders should increase the amount of equity and retained earnings to better cope with losses.

I am positive on China’s growth prospects in the long term. If you look at Vietnam which is struggling with 25% inflation and have devalued the Dong several times, the Chinese are actually prudent in taking bitter financial medicine before things get worse. It will be a great folly to bet against a country with $2.4 trillion dollars in foreign reserves. And let’s not forget that China still has much competitive labor and land to tap on as industries just relocate from the richer Eastern to Western or inner cities region for the next phase of growth.

Invest With Prudence

Commodities (like gold, silver, and grain) are expected to do well in the Year of Metal Tiger. The recent weakness in gold represents a good opportunity to accumulate. It is prudent to hold some gold in your portfolio while waiting for full effects of sovereign debts to play out. You never know if more fictitious statistics are uncovered, more money printing is needed or if wars will break out. War is always a convenient solution to divert people’s attention from economic woes and avoid uprisings.

However, gold will not chart a smooth path upwards. You can expect volatility, like gold falling back to $800, before it breaks new highs. Nevertheless, the fundamentals for gold remain intact and you should purchase gold (between 10-15% of your assets) for retirement purposes, instead of using it as a trading instrument.

If you are interested in bonds, it is not exactly a safe haven. If interest rates are raised later in the year coupled with sovereign debts failing in unison, bond prices could plunge drastically. Any positive momentum that comes from a Greece bailout will be short-lived. You will do well to sit on cash or fixed deposits than get into the bond market right now.

As for the stock market, I will say the Dow Jones range of 9500-10500 is not attractive for us to pick up any more stocks. If you are already vested, you can just sit tight as the stock market has a high probability (it is not guaranteed, investment decisions are usually made on probabilities) of making a 30% advance from 10000 DJI level. From there, it is up to you whether you want to sell or hold for the long term.

Conversely if there is any break below 9500, there are some bargains to look at. It is a good idea to invest progressively, about one-third of your spare cash on blue chips. Any more market dips will present opportunities to accumulate at lower prices.

Staying diversified and on the right side of the market is important to make profits for this year. Most importantly, don’t be greedy.

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2 Comments

Filed under Economy, Properties, Stocks, bonds, gold

2 Responses to Investing Pitfalls In the Year of Metal Tiger

  1. Hey there,

    Chanced upon your site. This post on the investing pitfalls for the year is very insightful. I agree especially for the china market, which i think is expanding too fast beyond its fundamentals.

  2. Thank you for the post, I found it very thorough. After the next five years, do you see a majority of countries embracing (costly) alternative energy, in spite of the developing economic landscape?

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