Two months of wrangling on the terms of financial aid was brought to bear as Greece received a bailout of €110bn over 3 years, sponsored by the EU-IMF. The olive branch was expected after Greece’s close brush with bankruptcy last week. All hell broke loose after European Union revised upwards Greece’s 2009 deficit to 13.6% of GDP and rating agencies downgraded its credit to junk status, limiting access to fresh funds.

The first disbursement of bailout money will be made before May 19 to avert a default, but there is no guarantee financial stability will prevail in the eurozone. If Greece bite the bullet and persevere to put its finances in order, they will face a recession and deflationary pressures which will cripple their economy for years.

However, given Greece’s abysmal record in fiscal discipline, it is doubtful if the austerity measures will be implemented fully. Greece promises to cut its budget deficit to 3% of GDP by 2014, but reining in spending is a tough call, with mounting political pressure from rioting workers and pensioners. From the initial response, a deadlock may ensue and hold the economy to ransom which essentially defeats the purpose of a bailout.

It is ironic that with this bailout, bond vigilantes have shifted their scrutiny to other debt laden nations in the Euro zone. Greece is but the tip of the iceberg, they came first to the party with hat in hand and are now safe, at least for a year. A dangerous precedent has been set though. How can Europe not save Portugal or Spain after handing Greece a lifeline?

Besides the PIGS (Portugal, Spain, Italy, Greece), you can count Austria, Belgium, Hungary, Ireland, and UK in the soverign default risk category. US and Japan have worrisome debt to GDP ratios too but because the former possess a reserve currency (licensed printing press), while the latter has a springwell of domestic savings to tap on for cheap government loans, their financial woes are not expected to blowup any time soon.

And since we are talking about irony, it is worth mentioning that the sovereign debt crisis is set to boomerang back to the banks which started the financial crisis with their reckless and greedy behavior. To prevent a total collapse during the darkest hours of the mayhem, European banks transferred toxic assets from their balance sheets onto the states, which were deemed better able to absorb such risks. Countries also adopted loose monetary policies to jump start their moribund economies. Add in lower tax revenues to these Keynesian efforts, the result is astronomical budget deficits.

The fact that European banks hold a lot of Greek, Portuguese, Italy and Spanish debts is not lost on investors, especially the ’shorts.’ If these countries default, the banks will definitely require another round of capital raising to bolster their balance sheets. But what if capital markets froze again and unlike 2008, you can’t bank on another bout of taxpayers’ rescue as fiscal budgets are already maxed out?

I hate to say this but financial Armageddon awaits Europe. As a monetary union, you have to sink or swim together. If more countries start asking for bailouts, the entire euro zone will face higher interest spread, and the euro could be non-existent if the political limitations of euro zone are not fixed.

Seeing how Europe struggles brought back memories of the Asian financial crisis in 1998. Not surprisingly, “Sell in May and go away” strikes a chord with many investors. The cliche does not always apply but it is a good rule of thumb. Historically, stock investing during the period from May-November is fraught with danger or at best rewarded with meager returns. Moreover, with a remarkable gain in the stock market (S&P having risen 75% since bottoming out in March 2009), it is time for a considerable pullback.

To be sure, a lot of positive news had been priced in amid the stock market rally. The V-shaped recovery and optimistic valuations appear realistic to many investors despite unfavorable aspects like high unemployment, rising debts, higher taxes, etc. While not exactly in a stock market mania, investors have cast aside their fear.

Thankfully, the stock market decline recently may keep our feet firmly on the ground. This is a time when investors should review their portfolios and make adjustments by offloading deadweight, shifting into defensive sectors and putting stop losses into place.

Usually, when investors shun stocks, they head for bonds market which are considered safer investments. You get a fixed income annually and if you hold it to maturity, you get back your principal. But bonds suffer from interest rate risk.

In the past, bond prices had plunged by 20-30% when interest rates double. As the US bond market is much larger than the stock market, many “risk averse” investors are going to feel poorer due to the losses from their fixed income assets.

When will Ben Bernanke raise interest rates is unclear but if futures on federal funds is any indication, the zero-rate policy is likely to be abandoned in November or December. Indeed, with the economy on the mend, Ben Bernanke has little excuse to delay raising interest rates and combat inflation. We may even see hyperinflation by 2012, thanks to energy/commodities which are in a secular bull market and the Fed’s misjudgment.

If you still favor bonds, you should go for short term Treasuries (3-6 months) because the longer the maturity date of your bonds, the higher your losses if rates surge. Right now, anything more than 2 years is a dangerous bet.

In the stock market, rising rates which translates to a higher cost of capital, will be detrimental to businesses but especially so for financial, property and construction counters. With higher instalments, investors will think twice about purchasing houses. The effect of lesser buyers coupled with desperate sellers who are on floating rate mortgages and about to reset higher will not be kind to the property sector. REITs, if they happen to have excessive debts and require refinancing, will also be tested once interest rates increase.

As for China, it is losing its lustre as a get-rich-quick destination right now. The government has clamped down hard on property speculators, restricted hot money inflows and outflows and it may yet raise banks’ reserve ratio requirement for the nation’s banks to 18%.

All these measures are calibrated to burst the bubble and yield benefits in the long term, but in the short run, nobody knows if the pendulum will swing too far and result in a second dip. Thus, parking cash in yuan, hoping there will be an appreciation, is not a sure bet if the Chinese economy cools down drastically.

Under such circumstances, gold remain the favorite asset for investors who love a safe haven. Even if gold achieved a year high of $1169, there is more upside to go. The frenzy which ensues from a Europe collapse will only add to gold’s appeal. And with the ongoing debasement of US dollar, gold has no direct competitor when it comes to preserving our purchasing power.

You can print out trillions of dollars to pick up the slack in the private sector or distort market machinations but you cannot change the primary trend which shows that stocks are in a secular bear market. Stock market can go up higher or lower but it has to come back to its equilibrium, say Dow Jones Index of 10,000, which is why some astute pundits have pointed out that this round figure is nothing to crow about and we will see more of it before the whole episode is over.

As I mentioned in my last post, this is not a year to attempt speculative activities and buying stocks aggressively is a dangerous approach. However, I do encourage buying on the dips, say after 10-15% correction. We have not seen the worst of the carnage which will probably gain momentum in June but if it is any consolation, there could be a rebound in early 2011.

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.

Rampant bullishness in the stock market disappeared over the past weeks and is likely to remain so till the end of the year. Stocks in various sectors (ranging from financial, property, construction, oil and energy) remain range-bound and though major indices are creeping up, they are being led by fewer counters and on low volume.

Bulls vs bears battle may be evenly split right now but according to most analysts, the stock market rally going into the new year is alive and kicking. Their forecasts of 1250-1300 are realistic enough with the 50-day moving average of 1,085 holding firm and could provide a launch pad for breakout in the coming weeks.

However, whether the S&P 500 can hold its ground till the end of 2010 is another question altogether. If you have gone through the internet and housing bust, you will know that analysts reports must be read with a healthy dose of skepticism. And when most of them agree, alarm bells should start ringing.

As a buy-and-hold investor, there are much to worry about, but you should enjoy the rosy picture of improving economic conditions being painted in the short term. Confidence in a robust economic growth has underpinned the optimism in stock markets.

US economic indicators are mixed but certainly more encouraging than in March. Expansion in the manufacturing sector is slowing down but the Federal Reserve’s industrial production report showed a month-over-month increase.

Jobless claims fell by 28,000 last week to 452,000 - the lowest level since Sept 2008 before the implosion of Lehman Brothers sent financial markets into a tailspin. Barack Obama is still not happy with the unemployment rate though and has urged banks to lend more aggressively to small businesses.

I am not sure if that is a good call because 133 banks have failed so far by acting against their better judgment during the boom years. It is actually refreshing to see banks exercising prudence and shoring up their balance sheets. But even if all the redtapes are removed, many businesses are still wary about expanding production and increasing payrolls when consumption is still anemic.

If businesses or consumers are not taking advantage of cheap loans, you can rest assure that speculators are relishing the zero interest rates. Herein lies the crux of the problem, the cheap cost of capital is actually doing little in creating jobs and demand. It is a jobless economic recovery.

Where has the money flowed to? A good guess is Asia which has seen asset prices rising up without supporting fundamentals like increasing income or productivity. A case in point is China which has seen land auctions fetching record prices in Guangzhou and in Shanghai recently, despite concerted measures to cool the red-hot market.

To quell investors’ uncertainty, China has committed to another 8% GDP growth for the year 2010. If they mean what they say, banks will not pull the stops on lending but they will certainly have to raise core capital to buffer against the prospect of more bad loans. With the momentum carried over from 2009, this 8% target is achievable. However, the Chinese government should be mindful of over-heating and ensuring that its frothy assets do not follow in the footsteps of Dubai.

The Singapore government has also predicted GDP growth for 2010 between 3-5%, on the back of improvements to global economic conditions. Meanwhile, Thailand have joined Malaysia and South Korea in reporting a turnaround in exports as they posted the first export increase in 13 months.

Without a doubt, economies are on the mend. How could it not after massive stimulus programs and additional fiscal burdens bore by governments around the world? The Federal Reserve must take credit for creating a feeling of “prosperity” with their Quantitative Easing and zero rates policy.

In their year-end meeting, the Fed indicated that interest rates will not be raised for an extended period, so that fledgling growth in the economy is not jeopardized. Such “accommodative” circumstances means champagne will continue to flow at the party. Investors have little choice but to pour their money into stocks, commodities or properties because deposits offer paltry returns while money printing turns their cash into trash.

Indeed, I believe stock markets may keep on rising in the short term. You can announce all the bad news right now and investors will not bat an eyelid. However, when market sentiment turns around, good news may be interpreted badly - whether the glass is half full or half empty is up to the analysts or big boys to decide.

There are a number of ways to give stock markets a rude awakening. The US dollar is staging a recovery as investors bet on imminent rate hikes and weakness of other major currencies. I have little love lost for the US dollar but compared to other major currencies, it is a safe haven. The euro may come under intense pressure if highly leveraged members start clamoring for bailouts.

The flight to safety could lead to the unwinding of carry trades which will further strengthen the dollar. During the financial crisis in 2007, the unraveling of the Japanese carry trade was painful. But it will pale in comparison to the destabilization created by a stampede out of the US dollar carry trade positions built up this year.

Even Jim Rogers who has been arguing that the US dollar is collapsing is buying dollar for the past two months. He remains a commodity bull and will sell dollar on the rebound. The US dollar dominance will not last but its revival means we should hedge our positions or take some profits.

Besides the US dollar gyrations, sovereign debts are another major concern. Last month, Dubai World dropped a bombshell when it requests for a standstill on debt repayment. The writing was actually on the wall for businesses in Dubai as they could not collect payments for months and projects came to a standstill, but for unknowing investors sold on the compelling Dubai fairytale, they were just not prepared that their “triple A safe” investments could again have the makings of a fraud.

The general assumption was that Dubai World is a government owned entity backed by oil revenues in UAE. However, that crashed to reality when the Dubai government distances itself from the the problems in Dubai World. Fortunately, the timely $10 billion loan provided by Abu Dhabi, on the day Nakheel was to default on its bonds, saved the bonds market from a confidence crisis.

However, before investors can heave a sigh of relief, the threat of Greece defaulting on its sovereign debts hit the headlines. Greece’s deficit stands at about 13% of GDP (close to the US level) while its debts are expected to rocket to 113% of GDP against an EU target of 60%. Clearly, such profligacy is a recipe for disaster.

Europe has no lender of last resort and the members are reluctant to pay for Greece’s irresponsible behavior out of moral reasons. Without a bailout, Greece has to slash deficits aggressively or face currency revaluation. Reduced spending and tax increases are inevitable but austerity is easier said than done, what with soaring unemployment, plunging asset prices as well as strikes and violence by anarchist mobs.

Pressure continues to pile on the Greek government after Moody downgraded its credit rating, following in the footsteps of Fitch and S&P. Due to the higher credit risk, the spread for Greece government bonds increased, implying higher interest rates for new or rollover loans.

Greece may be the first member of the European Union to be brought to its knees by the debt markets but it won’t be the last. Other participants in the debt binge include Austria, Belgium, Italy, Spain, UK, Japan, and not to forget America.

The US run larger deficits than any of its counterparts, to the tune of $1 trillion per year (maybe more with social and medicare obligations coming), the day of reckoning when lenders refuse to finance these deficits is approaching.

Yet, there is no sign of America slowing down in its spending, despite debts crossing $12 trillion. The Treasury expects the bailout to cost $200 billion less than expected, and that it should be able to recover most of the money it lent to financial firms.

Great news but if you think excess TARP funds can be directed towards cutting deficits, you are wrong. Obama is already planning for stimulus package III and Timothy Geithner wants to use the money to purchase Treasuries. The ideology of “deficits don’t matter” is too deeply engrained in America’s psyche.

If creditors start to get tough, will there be simultaneous sovereign defaults including America? William Buiter leaves us in no doubt, saying: “The massive build-up of sovereign debt as a result of the financial crisis and especially as a result of the severe contraction that followed the crisis, makes it all but inevitable that the final chapter of the crisis and its aftermath will involve sovereign default, perhaps dressed up as sovereign debt restructuring or even debt deferral….”

Investing In Gold

The global economy recovery depends on borrowed money. America will continue to spend until they can’t. Can your investments weather the shock of sovereign defaults? The best way to protect yourself is to buy a few ounces of gold.

Some analysts believe gold is a bubble but I don’t think so. Yes, it has fallen about 10% off its peak of $1226 an ounce and may even correct below $1000. Nevertheless, the fundamentals are intact to send gold higher in the next 5-6 years. Gold will react favorably to global stimulus efforts, which are forcing governments to print cash and erode purchasing power.

Inflationary pressures are building up strongly and will likely erase deflation in the new year. Inflation is a silent tax which affects everybody but for those who are are heavily leveraged, it lightens their burden as debts are paid with cheaper dollars. That is certainly more appealing than scrimping and depriving yourself of material comforts.

Compared to deflation where people hoard cash and demand declines, economists will like to convince us that inflation is good as it pushes up assets prices, provides jobs, increases income and investment and boost tax revenues.

Well, inflation will be back with a vengeance and that will be reflected in the commodities market. There is no need to keep track of the funny money created as gold preserves our wealth by tracking inflation closely.

Also, if you believe in Jim Rogers, commodities are in a bull market and we are only half way through. As a long-term gold investor, the daily movement in gold prices should not concern you. Just buy gold on the dips and sell only when gold reaches a mania.

Keep An Eye On The Exit

It bears remembering that the stock market is forward looking (about 6 months), so if you expect interest rate hikes in the later half of half of 2010, keep a close eye on the exit door when summer comes around.

When stocks are rising, it is easy to be suckered into the stock market as everybody wants a piece of the action. However, your world will come crashing down if the music stops after you invested your life savings. The key to successful investing is not to lose money or at least, not too much of it.

It is hard to stay on the right side of the bets all the time. You can be less wrong though if you choose sectors which are resistant to rate hikes, like gold and natural resources. The financial sector has hidden risks in delinquent mortgage loans, derivatives and sovereign defaults but having some exposure to quality financial stocks can provide strong upside potential.

For those who do not want to invest, it is best to save up your money and wait for better opportunities since valuations are high right now. Prices will definitely come down as we are in a secular bear market which may extend beyond 2015, if we consider 1999 as a starting point.

I suggest fixed deposits as the best option to preserve your principal. They are guaranteed by the state, in the case of bank runs. Long-term bonds or structured deposits are not fail-proof.

While they offer higher yields than fixed deposits, the returns have to weighed against exposure to credit risk. Ask yourself if it is worth getting the slightly higher yield, only to suffer losses to your principal in a black-swan event, which can wipe out your returns many times over.

That is all for now. Happy New Year to you guys. By the way, what are your investment expectations in the new year? More profits or losses? Going all out or cutting back?

It is unclear how well the balance sheets of the remaining Wall Street bastions stand up to scrutiny when interest rates are raised, mark to market accounting resumed and all the fanciful Fed’s creations (like Primary Dealer Credit Facility, Commercial Paper Funding Facility, Term Asset-Backed Securities Loan Facility, Term Securities Lending Facility Options Program, etc) are withdrawn.

Ben Bernanke is reluctant to raise low interest rates but he has been quick to toast his “success” in saving America and the world from financial meltdown. Bernanke said: “History is full of examples in which the policy responses to financial crises have been slow and inadequate, often resulting ultimately in greater economic damage and increased fiscal costs. In this episode, by contrast, policymakers responded with speed and force to arrest a rapidly deteriorating and dangerous situation.”

While Ben Bernanke’s resolve in throwing money from his helicopter is impressive, history will remember him fondly not for the amount of dollars he can print in record time nor his financial creativity but rather the exquisite timing of his exit strategies. Liquidity injections canot continue indefinitely without leading to massive asset bubbles. The Fed will have to pull the trigger (I hope sooner rather than later) and that will lead to a shakeout for equities, commodities and dollar short-sellers.

Harsh facts are never appreciated when everybody is having fun at the party. Lest I keep repeating the same old bleak story and being deemed as a gate-crasher or scare-monger, I have refrained from posting too often in this blog. But it will be remiss of me not to mention that this rampant bullishness prevading the stock market is raising alarm bells.

Today, we are, at best, peering into a nascent economic recovery but Dow Jones Industrial Average have already crossed 10,000 (about 30% off the all time high of 14,198 in October 2007) when peak euphoria reigns amongst investors. If that is not getting ahead of ourselves, I don’t know what is.

Bank of America gave us a measure of reality by reporting a $1 billion loss, its fifth straight quarterly loss. To be sure, the financial sector is still in murky waters. What has changed over the last year is not the debt crisis but rather a reshuffling of cards. Instead of transferring risks to unknowing investors through securitized debts, the US government has been forced to gobble these toxic assets and shoulder immense financial risk.

The solvency of major financial institutions has come at the expense of insolvency to the US government. If financial institutions get into trouble again, what are the odds of the US government mustering another rescue when its credit is hanging in the air? Can the Federal Reserve double money supply as coolly it did over the last year? Will taxpayers, consumers and investors not bat an eyelid as their purchasing power and dollar denominated assets go into the dumps?

Knowing that the next financial crisis could require as much, if not, more resources to resolve, and the Federal Reserve could be found sorely lacking by then as the dollar loses its status as the world’s reserve currency, it is rather baffling that financial institutions are still resisting reforms to get their house in order. Perhaps it is inevitable that this unregulated financial system, as we know it today, has to crash into oblivion and be rebuilt from the ground up again.

I have nothing against attractive remuneration for top performers. You can’t fault traders who netted, say, $1 billion and they lay claim to 50% of profits while the owners and creditors who came up with the capital get the rest. However, when the traders lose $3 billion the following year and even compromised the company’s financial position, they lose nothing except their bonuses or jobs while shareholders, bondholders and even taxpayers have to step in to pick up the tab. Capitalism is not about privatising rewards while socialising the risks, but apparently the rules of the games can be changed.

Dollar Crisis And Commodities Boom?

Reckless money printing by the Federal Reserve has devalued the dollar, and we can expect a dollar crisis to play out within the next decade. Already, murmurs of discontent are getting louder amongst key players.

Rumors are rife that a meeting among Arab States, China, Russia, and France hopes for a discontinuation of oil trading in U.S. dollars. In the short term though, the dollar could strengthen as the stock market experience a major setback but its demise is inevitable if federal debts continue to pile up and the US economy weakens.

Currently, the US government is not in a hurry to defend the dollar. Without turning off the printing presses and reining in excess liquidity, Timothy Geither has only paid lip service to the notion that that America supports a strong US dollar. Exporting nations in Asia are left with little choice but to implement currency intervention, in light of narrowing US trade deficit which signals a rebound in US exports.

The dollar crisis has lent weight to investors like Jim Rogers who believe that commodities is the best place to be. I don’t doubt his words as supply and demand support his judgment. In fact, crude oil could very well run out in a generation’s time. If oil continues its uptrend, other commodities (food, metals, etc) are bound to follow.

But until the global economy gets back on a firm footing, any commoditiy boom is far-fetched. China, in its bid to sustain 8% economic growth for “social stability,” may well have decoupled from the deflationary environment in the US. China’s voracious domestic consumption is looking very promising, just over their eight day National Day holidays, retail sales of consumer goods surged 570 billion yuan, up 18% compared to last year.

But it is impossible for the Chinese to pick up all the slack in global consumption. Thus, while a collapse in commodities is unlikely, prices may fall from current levels and stay low for a while. That will actually benefit a weak US economy which is 70% dependent on consumption.

Printing more money which results in inflation and then runaway prices of oil and food is self-defeating. Raising interest rates will cause a sell-off in commodities which is a boon for consumers and businesses rather than a stock market rally fuelled by speculation and greed.

For those who are thinking of using commodities as an inflation hedge, it is also not a wise idea. Fortunes can be made or lost on a wrong bet, even for seasoned investors who study technicals and fundamentals closely.

A Global Double Dip Recession

Another rapid slump in global economy is far from impossible. Double dip recession could arise from sky-high public debts or another financial crisis sparked by delinquency in prime mortgage loans, risky commercial sector or derivatives. Geopolitical rivalries in the Middle East and Noth Korea also threaten stability. And not to forget trade conflicts which could result in protectionism or rather beggar thy neighbor policies.

If the global economy slids back again, a fresh round of stimulus packages could be harder to coordinate in the face of precarious budget deficits and debts. This could be the start of a multi-year recession, lasting at least 3 - 5 years.

America is moving in a similar trajectory as Japan when they lost their way after a housing bubble burst in the ’90s and bad loans overwhelmed their financial system. Till today, Japan has not really emerged from its lost decade. It is too early to say if Ben Bernanke has steered America away from the crippling deflation which plagued Japan or banished the ghost of the Great Depression.

Despite the stock market rally, consumer spending has not picked up. Equities may have enriched a select few but Americans are still struggling with job losses and lower income. In August, it was reported that consumer debt declined a further $12 billion, marking the seventh month of debt contraction in a row.

Since the credit crisis struck, consumers have reduced their debt by a record $113 billion (excluding mortgages). Either Americans are tired of using credit for discretionary spending or the credit crunch has not really abated as banks remain fearful of making loans.

Not surprisingly, US retail sales fell in September after the Cash for Clunkers program ended. Hopes are now on the fourth quarter where the retail industry brings in the bulk of its profit but I am keeping my fingers crossed as record unemployment will dampen holiday sales.

Dark Clouds Behind Singapore’s Economy Recovery

Singapore was the first Asian nation to announce a recession but its economy has rebounded with an 14.9% expansion (following the 22% growth in the second quarter), prompting the government to raise its full-year economic outlook. Being an export oriented nation, our modest recovery bodes well for the health of most Asian economies.

Nevertheless, MAS has kept its monetary policy steady, being cautious about the sustainability of this recovery. If private consumption in the developed nations do not increase when effects of stimulus programs wear off, we have to brace ourselves for a W-shaped recovery.

There is no doubt that things are picking up but it is too early to pop the champagne. In fact, I believe next year will be similarly, if not, more challenging. The sole pillar of our economy during this harsh recession was the construction industry which attained double digits growth while other sectors languished.

However, this sector is losing some steam. As it is, construction dipped by 0.6% while manufacturing and services were up 35% and 9.5% respectively. There could be more contraction to come. Due to lacklustre interest from buyers in 2008, many developers were vexed by their inventories and were on the verge of selling at greatly discounted prices. Interest in bidding for new plots of land was scant. Fortunately, demand for mass market residential properties spiked in recent months. 

Construction companies will feel the brunt of this “quiet” period next year, just when most of their existing projects are completed. Competition for new projects, especially from the private sector, will be keener, driving down prices. We can expect fewer companies reporting fat profits and there could even be a weeding out of the weak players which will increase unemployment figures.

The integrated resorts (two biggest construction projects in Singapore) are scheduled for completion by mid 2010. Whether new public projects can absorb all the resources being freed up remains to be seen. The “idle” situation may persist for a while as private developers are still building their land banks and the planning and approval process takes time. Hopefully, by then, other sectors of the economy will have firmed up sufficiently.

In view of the challenging times ahead, I believe the stock market is too optimistic with its valuations of 15-25 times earnings. Stocks have rallied aggressively since March. Most of them are trading above their 200-day moving average and with no sign of slowing down. In this kind of bullish environment, fundamental analysis seems really foolish. A monkey, with no baggge of knowing how bad things really are, could have made huge profits just by throwing darts in the dark. 

It is at moments like these when rational investors are blinded by greed and let their guard down. If you are seduced by lucrative gains made from stock market speculation, count yourself in good company.

Sir Issac Newton, a man renowned for his achievements in the field of physics, was left in financial ruin when he succumbed to the South Sea bubble. In 1720, the South Sea Company’s shares soared before plummeting and becoming worthless. It has no viable business but it was able to issue shares due to insatiable demand from investors, aided by rumors and speculation.

We should not forget that in the short term, the stock market behaves like a voting machine, swayed by emotions and fuelled by momentum, but in the long term, it is a weighing machine. Fundamentals have to come into play but of course, the million dollar question is when. Unfortunately, nobody can time the market accurately.

The bullish momentum may not exhaust itself just yet as there are no shortage of investors coming round to the idea that “this time, it is different,” so more cash is expected to flow into the stock market. It is getting close to a final hurrah though.

Rather than being obsessed with calling a market top, we should just maintain a neutral stance and stay vested, or for the risk averse, take profits off the table (which I have done progressively since August). By divesting all our stock holdings, we may miss out on more upside. I am not keen to buy more stocks but if you want to do so, remember to keep your stop losses tight and never maximise your leverage.

Green shoots have “blossomed” but it is during such exuberant times that we have to be cautious. Of late, I noticed that the debate has intensified on whether the stock market has topped or will continue to break-out. In the last week of August, there are days when the stock market came under furious selling pressure at the open, only to end in positive region by aggressive buying towards the end of trading sessions.

Clearly, there are manipulative forces at play, aided by a media which put a positive spin on any economic news. As they say, less bad is the new good. But the rally will not work without greater fools hopping on the bandwagon. What eager retail investors see is the stock market advancing each day, thus they are happy to stay vested and let their profits ride.

If the Federal Reserve hikes interest rates and stops creating money from thin air tomorrow, the party will be over but since that is not likely to happen and the US stock market is buoyed by so much liquidity, I wouldn’t be surprised that there is more upside to this rally.

However, given that September is historically the worst month of the year and with some big boys getting uneasy, selling pressure could escalate in the coming weeks as they unload their huge inventories of stocks.

Already, interest in US stocks is waning. Last week, trading was dominated by a few counters, namely the notorious gang of nationalized financial institutions (Fannie Mae, Citigroup, AIG, and Freddie Mac). If the top traded stocks are discounted, market volume is pretty thin which doesn’t make a convincing case for the stock market rally to continue.

In Singapore, penny stocks came into focus while blue chips fail to break out from the highs set in late July and are mostly undergoing consolidation. While some penny stocks warrant a long-overdue value discovery due to their low P/E ratios, I am surprised that investors are jumping headlong into stocks which are struggling with dismal operating cash flows and refinancing woes.

Of greater concern is the Shanghai Composite Index. It was quick to awaken from its slumber back when the world were still skeptical of the first sightings of green shoots. However, the behavior of the index has been anything but robust in August, tumbling 22% after registering seven consecutive monthly gains. On Monday, the index plummeted 6.7% to a three-month closing low and its second-biggest monthly loss in 15 years.

China policymakers have warned that unprecedented lending aimed at fighting off the economic downturn could be withdrawn and have signaled its worry about overcapacity in the steel and cement industry. According to the latest Reuters poll, Chinese fund managers have reduced their allocation to equities for the first time in six months.

This is a clear sign that investors sentiment are weakened by concerns over shrinking liquidity. Demand for stocks also declined as investors grew jittery over sky-high valuations which stood at odds to corporate earnings and dividend yield. The further stocks rises, the more unbalanced the Chinese stock market as it pulls away from fundamentals. In addition, a boom in initial public offerings has also mopped up much liquidity in the system.

Residential Properties Overheating Again

Many people are still struggling with defaults and foreclosures but there are no shortage of new investors willing to take a bite of this fruit and see for themselves if the pain of foreclosures is real. The moribund property sector is back in business. In fact, it is in rip-roaring form. 

In some locations, China property values already rival Hongkong, Singapore and US in terms of cost per square meter but the per capita income of China workers is about US$6000, lowest among its counterparts. If speculation is not curbed, affordability and valuation may be skewed dangerously. 

Though the Chinese governmnet is intent on achieving 8% economic growth to maintain internal stability and investors’ confidence, a housing bust will derail their plans and possibly spark mass civil unrest. I believe they are right in restricting loans from being funneled into the property and share markets but trying to stay on top of the bubbly situation is tricky, without damaging any nascent recovery.

In Singapore, crowds are thronging sales room, queuing up overnight, handing over blank cheques, all in the hope of snapping up residential properties (see here and here). The price for some of these condominums, in sub-urban locations and on 99 year leasehold, is not cheap, to say the least. Yet, the projects were launched to great fanfare and selling like hotcakes.

Wasn’t it only in February that developers were worried about mass defaults and banks making huge provisions for non-performing loans? I doubt if such interest is sustainable. Currently, rental yields are not impressive and unlikely to improve with more supply entering the market. Unemployment figures, though not getting worse, are not pretty either.

At this frenzied rate, I believe there could be another bust in the housing sector by 2011 or 2012 and this could be the real bottom when people swear off investment in housing for a long time. For developers and the construction industry, this is bad news but something which has to be expected as part of a business cycle.

Banks who hold mortgages will also be in trouble if the economy nosedives again and jobless rate spikes. The problem with banks is that when times are good, they are extremely flexible and generous with their loans, so long as they can get a bigger piece of the action. Customers, for better or worse, are spoilt for choice, thanks to their financial engineering.

I have nothing against financial engineering. Given that individual consumers have different financial goals and background, tailoring loan packages according to their needs is supposed to be a boon. However, the US housing crisis has taught us that financial engineering is not as helpful as it seems. Unless you know what you are getting into, plain vanilla fixed mortgages is still the best option.

At the height of the housing boom, a lot of subprime debtors were sweet-talked into taking on loans with adjustable rate mortgages so that they can buy bigger houses which are beyond their affordability level. Some even went for negative amortization (ie, they pay less than interest only on housing-backed debt) and the result is that every month, their amount of debt increases despite making payments. Not surprisingly, foreclosures have exploded in states like California and Florida where such loans are concentrated.

Economic Recovery Without US Consumers?

We have been drilled often by media reports that the worst is now behind us. There are broad signs of stabilization and emerging growth but is it time to pop the champagne? Can we expect the same heady, export-led growth, prior to the 2006 subprime crisis?

You know, those groovy days where American consumers spend beyond their means? During those reckless decades, American consumers expend whatever avenues of credit available to them -  refinancing their homes, maxing out credit cards, taking loans for vehicles, second homes, and education.

The US government and export oriented markets will like to see American consumers get back to their old spending habits but the deleveraging process is far from over. Banks are still expecting over-extended Americans to pay down existing debts first before lending more money. You can’t blame the banks, when they are in trouble, they become cautious and avoid lending money, regardless of your credit history.

Unless wages increase or the government takes on more debts to issue stimulus packages, there are not much discretionary cash for consumers. The US government is making some headway in stoking the spending psyche of Americans through programs like Cash for Clunkers and cash for refrigerators but it is unclear how much of a multiplier effect they have on the economy. 

I doubt Americans are in a hurry to take on more credit for spending purposes. Frugality is the new order. Savings have risen and and consumer spending patterns are changing. This could have adverse impact on the US economy which is 70% driven by consumer spending. 

Worsening Credit Of US Government

84 US banks have already failed in 2009. If the 1980s savings and loans crisis is any indication, this is only the tip of the iceberg. There is also a strong suspicion that the Federal Reserve is still propping up some of the too-big-to-fail US banks, without which a catasphore could wreck the financial markets again. The Fed is fighting tooth and nail against full disclosure of its dealings but it is clear that financial institutions are not out of the woods.

In order to rescue the financial markets, the US government has put its credit on the line by bailing out shaky institutions and offering guarantees on deposits and loans. Obama has also revealed that America is likely to increase its debts by $9 trillion in the next ten years. Add this figure to the existing $12 trillion of federal debts, that is more than $20 trillion.

Assuming an interest rate of 5%, that is about $1 trillion which has to be allocated in the budget to pay creditors yearly. Where is Uncle Sam going to get the bulk of this money except to turn to its printing press? And we are not even thinking about other liabilities in its social security and health care.

Is there a point where the party stops and nothing works anymore? Very likely yes. The Federal Reserve cannot cause the market to rise indefinitely by printing money at will. Its status as the global reserve currency is at stake after abusing it for so long.

It is a matter of time before we experience another major recession because the key lessons from this financial crisis were forgotten easily and people are back to their greedy speculative ways. But the next time round, the Federal Reserve may find its hands tied, with very few options available. 

The financial market may not respond as positively to a deeply insolvent America issuing another $700 billion TARP fund or its wafer-thin guarantee of deposits for the next crisis. If the situation spirals out of control, there could be bank runs, bank holidays or even total economic shutdown till everything is sorted out, which means that a lot of what we own is at risk of becoming irrelevant in a new world order.

As a lot of economic activities and assets are denominated in US dollars, the problem arising from this battered reserve currency is not confined to America alone. Clearly, there are some tough monetary issues which have to resolved during calmer moments.

I believe the stock market is likely to dip again before embarking on another bull run but don’t try timing the market as it is a matter of luck and has little to do with superior foresight. Instead of being obsessed with selling at the peak and buying right at the trough, we should adjust our portfolio allocation at this point of time and not be overly exposed to stocks.

Whether the stock market or property market advances further or dramatically declines, having a healthy cash hoard gives us the flexibility to buy on the dips and not rush into panic decisions.