Aug

10

Don’t Bet On A V-shaped Economy Recovery

August 10, 2009 | 6 Comments

Are stock markets heading for a breather? Euphoria surrounding Asian equities have cooled down considerably over the past week, prompted by profit taking amid concerns that stock valuations ramped up too fast and are inconsistent with underlying earnings.

More importantly, China declared its intent to rein in the flood of new bank loans to the tune of Rmb7,370bn (more than twice the amount lent last year), many of which appear to be speculative in nature.

Recently, Chinese regulators ordered banks to ensure the record number of new loans are funnelled into the real economy and not to inflate asset bubbles in the equity or real estate markets. Banks must now monitor how their loans are spent and that has temporarily stopped the red-hot Shanghai stock market in its track.

Over in Europe, economic conditions are looking more promising but they are not out of the woods yet. German industrial production fell 0.1% as compared to an estimated increase of 0.5%. The UK economy has a smaller contraction for the second quarter but weaknesses persist in the financial and business services sector.

The Bank of England’s decision to increase the size of its asset purchase program shows that the UK financial system is still suffering from deleveraging and a deluge of toxic assets. Compared to leading US financial institutions which are sheltered by the Federal Reserve, European banks have more dark days ahead.

Don’t expect them to report blow-out earnings on the scale of Goldman Sachs. In fact, Royal Bank of Scotland just reported huge losses of 1.04 billion pounds, despite revenue increasing 58%. The loss was mainly due to an increase in bad debts to 7.5 billion pounds.

Meanwhile, the European Central Bank has provided about $600 billion financing to the banking system as it foresaw a credit crunch in the fall and may be taking advantage of this bullish period to create a buffer against a possible funding shortfall.

As for the US stock market, it closed on a high last week after rebounding from early weaknesses due to an optimistic report by the US Labor Department. Unemployment rate slipped lower to 9.4% from the forecast 9.6%. Nevertheless, jobless claims increased which means jobs remain scarce and businesses are not expanding as fast as the heady stock market suggests.

The better than expected US jobs data is likely to reinforce the view that the economy is stabilizing after a generational financial crisis. Some economists have even suggested that the economy will rebound strongly in the third quarter, with a surge in vehicle production. However, any fledging recovery could still be threatened by strong economic headwinds.

The latest Federal Reserve credit report revealed a drop for the fifth straight month. Banks’ restrictive lending, unemployment, stagnant wages and falling home values resulted in reluctance of households to borrow money for spending. With debt weary US consumers (which accounts for 70% US GDP), the US economy and export markets will not be in a hurry to rush into a V-shaped recovery even as the recession eases.

It is hard to say if the US economy has recovered or just a mirage caused by Quantitative Easing but there is little doubt green shoots have come at the expense of the federal balance sheet which was compromised by unprecedented debts. The US government is determined to keep its financial system from failing, ease the credit cruch and prevent deflation. It has turned to printing money furiously which has tarnished much of the US dollar’s safe haven status.

The massive money created out of thin air has caused consternation amongst foreign creditors and investors. Their lack of participation in US Treasury auctions will result in higher cost of borrowing (higher yields and lower prices of bonds), and that leaves the Fed with little choice but to monetize its own debt, with further dire implications on the US dollar.

In the past, China depends heavily on US export market and has a keen interest to prevent its currency from appreciating. They do so by purchasing and propping the price of US denominated assets.

But with America in doldrums, China has to implement its own stimulus package to offset the weak export market and maintain an 8% growth through public infrastructure spending, investment and consumer spending. As inflationary pressures build up, a stronger yuan may be a more useful weapon for the central bank. There is little incentive to continue bolstering the US dollar.

As the US dollar risk losing its function as a store of value, investors may consider a diversified approach to sitting on cash. Gold has intrinsic value that cannot be created at will and is a prized asset for those who lost their confidence in fiat currencies.

I believe gold is an important component in our portfolio mainly for insurance against inflation rather than capital gain. Stocks have got ahead of themselves and most coporate earnings are barely satisfactory. I will certainly not add on to positions at such valuations. Even if the stock market collapses, we should only play with money we can afford to lose.

Investing in the stock market is a venture that is skewed against retail investors and one has to be avoid excessive leverage in chasing profits as market directions can turn on a dime. Retail investors are helpless against financial institutions equipped with state of the art technology and algorithms which allow them to see what cards market participants are playing in split seconds. This will allow the big banks to front run customers and skim profits from every trade.

Goldman Sachs just brought criminal charges against one of their programmers for stealing a software program that allowed them to front-run their own customers. In their criminal complaint, they said the software would allow someone to manipulate the stock market.

Now, isn’t this admission very disturbing? If you are considering cashing out your retirement nest, maxing out your margin account or taking out home equity loans to invest in the stock market, you could get burned very badly.

It is a matter of time that the rampant bullishness in stock markets ends. There are other dark clouds over the horizon which do not square with the possibility of a V-shaped economic recovery. CIT, the troubled commerical lender that serves small and midsize retailers and manufacturers, is still struggling to survive and if it does file for bankruptcy, the impact on US businesses could be severe.

Confidence could take a further hit as California IOUs don’t seem to be working very well. The state may have a budget now but any hopes of redeeming the IOUs is far away. Already, some contractors have sued California for paying in IOUs. Said William M. Audet, lawyer for the plaintiff, “The state is forcing people to accept these pieces of paper and pay taxes on them. Small businesses are closing, and more will close by the time the state redeems these warrants.”

Also, problems in the financial system remain hidden. Derivatives, all $600 trillion of them, show that there are far more debt in the world than assets to cover it. To reduce them into something more manageable could wreck havoc once again on financial markets. While derivatives are zero-sum games which does not benefit the economy in terms of tangible production, they do serve a purpose in risk management.

Derivatives are necessary for businesses which need to hedge against risks like interest rates or foreign exchange losses but there are investors who indulge in such contracts for the purpose which can only be best described as gambling. Such investors play with money they don’t have and since most derivatives are written over the counter without checks and supervision, you have to depend on the good faith and credit of the counterparty which in some cases, contain dubious risk profiles.

It is clear that the unravelling of derivatives will have severe implications on the stock market but nobody seem interested in implementing a framework to safely regulate such activities. Maybe we should just wait for the whole thing to blow up before taking action.

Another factor which will impact economic recovery is rising crude oil prices. As the global economy recovers, demand of crude oil will increase exponentially even as supply is depleted irreversibly. Crude oil may face downward pressure as rumors surfaced that the Federal Trade Commission would impose fines on market abuse.

This will prevent excess speculation but the fact remains that we are approaching or have passed peak oil. Market forces will drive oil prices beyond the average consumers’ affordability levels, long before the last drop of oil is exhausted.

We can expect oil prices to eat into the profits of businesses and discretionary income of consumers, jeopardising the prospects of a V-shaped economic recovery. Perhaps some economic activities will be forced into a standstill or rendered redundant when oil reaches $300 or more per barrel.

As for residential properties, they are enjoying a new lease of life (long queues, blank checks and scruffles in show rooms), I doubt they are sustainable. The stimulatory effects and loose monetary policies have propped prices for properties but they are not accurate reflections of demand, affordability or a lack of good properties. In fact, the supply chain is strong as there are many deferred projects waiting to be launched.

In conclusion, I am keeping my fingers crossed on a sustainable recovery in the economy. The rampant bullishness was able to cover some horrific earnings but the likelihood of another crash is quite high. In fact, I would not be surprised to see stocks drastically correct by October.

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More on this topic (What's this?)
5 Key Market Signals to Know Before You Invest (Contrarian Profits, 8/5/09)
V-SHAPED OR W-SHAPED? (THE PRAGMATIC CAPITALIST, 8/21/09)
David Rosenberg: A "V"- Shaped Recovery (Expected Returns, 10/9/09)
Read more on V-shaped recession at Wikinvest

Jul

22

Stay Nimble For Your Investment

July 22, 2009 | 2 Comments

I did a double take when I saw this news:

The inspector general for the $700 billion TARP scheme tallied about 50 initiatives set up by the Bush/Obama administrations and the Federal Reserve and came to the conclusion that “the US government’s maximum exposure to financial institutions since 2007 could total nearly $24 trillion, or about $80,000 for every American.”

Sheesh… for those who have a million dollars or more in their bank accounts, $80,000 to save the financial markets is chump change but for most blue collar workers, that could very well be their net worth.

To be sure, the $24 trillion is the gross and not net exposure. Most likely, the full amount will not be used. But the astronomical amount of money at stake makes the effort of most Americans who have turned to frugality and saving money seem insignificant.

Anyway back to the stock market. After seven consecutive sessions of gains, market sentiment has turned slightly cautious. Technically, the averages show that stocks are overbought, which increases the risk factor but because they have broken out above early June highs, the upward momentum is not likely to fizzle out immediately.

Indeed, the stock market rally has fooled many investors with its longevity and I am glad that I did not sell off all my stocks. Blow-out earnings from leading banks (Goldman Sachs and JP Morgan) renewed market optimism and reversed a bearish head and shoulders pattern.

Strong profits from the financial sector are actually not surprising considering the low interest rates (effectively 0%), mark to market accounting thrown aside, and the value at risk for trading activities soaring to record levels. In addition, low earnings forecasts across the board make it easier to surpass expectations.

Investors were further emboldened after a temporary reprieve for CIT from bankruptcy and a string of better-than-expected corporate earnings filtered in. Nevertheless, the euphoria for commodities and equities might prove to be transitory. Thus, I am not keen to add to my positions amid increased appetite for speculation.

Due to weak consumers’ demand, it is still highly suspect if earnings from the real economy can consistently outperform expectations in the months ahead. Before the financial crisis, most individuals and businesses stretched their budgets and leveraged to the hilt. Well, it finally hit home that nobody get rich by spending beyond their means.

The years of easy credit is unsustainable and most likely over. If Americans are squirreling money away for a rainy day, then the only hope for the global economy to power ahead lies with emerging markets.

A case in point is the booming Chinese market. China reported an impressive 7.9% growth in their economy in the 2nd quarter while the U.S. and Europe remain mired in recession. China’s 4 trillion-yuan ($585 billion) stimulus package has worked like a charm - domestic consumption and infrastructure works have more than compensated for the decline in exports.

We are also told that China’s stockpile of currency rose by a record $178 billion in the second quarter. The US definitely need China’s continued support to fund unprecedented amounts of debts. In a further show of strength, China has overtook Japan as the world’s second-largest stock market by value for the first time in 18 months. Slowly but surely, Japan’s large but ailing economy is losing its influence.

At the moment, I am sticking to my view that the stock market rally is overdone and there is a good chance of buying on the dips again. We have come a long way from the March lows when stocks fell far below their peak, and a stock market rally is justified by long-term fundamentals. As more disbelievers wade in to capture a piece of action before they miss out on more profits, the stock market rally stretched into months.

However, the recent rally has priced in very rosy earnings for many sectors in anticipation of a full-fledged recovery. Such optimism will allow bears to force the stock market lower in the later part of 2009 when the outlook for earnings in the real economy turns bleak or more time bombs in the commercial and prime mortgages explode.

Instead of a lengthy consolidation, the stock market has broken its previous resistance aggressively. Though investors are now behaving like sex-starved addicts in a harem and are ready to invest at any hint of positive news, do not forget that market sentiment can turn on a dime. The result is that there are air pockets instead of firm support at the bottom, and that makes a major correction inevitable. 

Some experts have postulated that we are entering a 20-year bear market, with rallies occurring intermittently and the worse is yet to come. We are now a few weeks away from challenging the record “longest” stock market rally of 155 days which happen in November 1929. The drastic stock market correction and prolonged economic malaise thereafter is something which I do not hope for, but nevertheless a distinct possiblity.

A major correction will really test investors’ resolve. After experiencing these bear traps a few times and the stocks retreat to unprecedented lows, investors will give up stocks altogether. Judging from the buoyant mood in the stock market. we are not at the depressed level yet.

So far, we have seen complex toxic financial instruments, frauds, Ponzi schemes and creative accounting come out of the woodwork. Usually, the greater the deception, the more severe will be the depression. We can heave a sigh of relief if most ills in the financial system has surfaced already. Unfortunately, that is a tough guess.

As for the housing sector, there is a renewed spat of buying. It is true that houses are much cheaper than in 2007 but they are not necessarily more affordable. The falling prices is a reaction to lower income and employment. Credit has also dried up as mortgage lenders become more cautious about whom they lent money.

Another property bubble could be brewing. Speculators are hanging on to the common refrain that “houses always go up in price” and are rushing to snap up new offerings. Prices may have stabilized currently but not bottomed yet. Thus, hopes for huge capital gains may not be realistic.

That is not to say we should shun properties. If you intend to stay in your house, then it is a good place to park your surplus cash. A house offers you a roof over your head and is a very durable asset (which cost money to maintain). When you take on a 30 year fixed rate loan, chances are that you are paying off the loan with cheaper dollars as inflation rears its ugly head. But if you are seeking investment grade properties, they will probably not appear in another 2-3 years time.

Because of the liquidity being pumped into the financial system by the Federal Reserve, nobody in his right mind will sit fully on cash and let inflation eat into their wealth. It is difficult to know how much further this rally will last. Is it exhausted already or the start of another massive bull run?

The bulls feel that “prosperity is around the corner” and that this recession, like others since World War II, will end as soon as the stock market, as a leading indicator, recovers and people start spending again.

I am inclined towards the view that things are picking up but the possiblity of another major correction is never far from my mind. On the technical side, there is room for huge rallies, but there is also room for plenty of misery.

The key is not to be overexposed to the stock market and stay nimble as the opportunities that present themselves may not follow traditional recovery patterns. Stocks could be depressed further or languish for years, so if you see the need to take profits off the table, then just do it.

While there will be quarters of positive economic growth ahead and the recession could even be declared officially over in the coming months, the radical economic reorganization that is slated by policy makers or will be forced upon by circumstances will change the macro economic landscape as we know it.

Jul

5

More US Bailouts Dampen Market Sentiment

July 5, 2009 | Leave a Comment

Since the last week of June, the stock market has whipsawed in a tight range. Gone is the hot-headed exuberance but neither has a drastic correction materialize. Some bulls are still holding the fort amid a thin market volume, but deciphering market sentiment is difficult as false signals can be easily generated by a few market participants.

Not surprisingly, a cautious mood has descended on investors as they await the next major move in the stock market. During this lacklustre period (a good excuse for not updating this blog), what gives for July? For one thing, there is the hugely anticipated second quarter earnings reports which will either lend credence to green shoots theory or spark a fresh round of selling as optimism is shown to have overtaken reality by a mile.

Most Asian stocks fell over the week. Hongkong has a turbulent session as financial and property stocks declined but it clawed its way back to end a 3 day losing streak. Japan, the world’s second largest economy by GDP, is a really sad story as its “lost decade” is now well into its 19th year. To add to its woes, it suffered its first trade deficit in 28 years.

This is expected since Japan cannot export what the world won’t buy (especially America) and an appreciating yen doesn’t help its exports. Domestic consumption is also fragile, with its aging population, low birth rates and a struggling workforce. Currently, manufacturing sentiment is on the mend but still fared worse than expected. In fact, Japan’s manufacturers plan to trim capital expenditures by a record 24.3% for this fiscal year, exceeding estimates of 13.2%.

I don’t harbor hopes of Japan leading the world out of this Great Recession. If it can get its house in order, and not be the first to declare a Depression, it is already an achievement. On the other hand, China has the potential to eclipse Japan as Asia’s economic powerhouse in the next decade. The Shanghai Composite Index is on a roll, finishing up at a 13-month high.

China turned in a good manufacturing report and its PMI boosted confidence, rising to 53.2 in June (from 53.1 in May), above the watershed mark of 50 for a fourth month in a row. Clearly, its stimulus which amounts to 20% of their GDP is working.

However, it is debateable if the high asset prices are sustainable when much of the world is still in a slumber. Even if the Chinese recovery story (propelled by domestic consumption) is compelling, irrational exuberance is a threat as investors are buying into stocks regardless of valuations.

As for the developed world, it presented little cheer for investors. Europe is hit hard by the highest jobless rate since the EU was formed 16 years ago. 9.5% of the citizens are unemployed in May (up from 9.3% in April). That is 15 million unproductive people depending on handouts, and unemployment is not expected to peak until 2010 when it reaches 11.5%.

US jobless rates were equally awful. Non-Farm Payrolls fell 467,000, much worse than the expected 350,000 job losses. Unemployment climbs to 9.5% from 9.4% last month. So much for green shoots when unemployment rate is still increasing. The global economy will take months, if not years, to recover which makes the run-up in oil prices all the more baffling.

Since March, oil prices have doubled as investors plumped for oil, not only to hedge against inflation but also to profit from the contango trade. But oil prices will face strong resistance from poor demand, especially when workers and the unemployed drive less and buy fewer goods while factories shut down, saving on electricity.

For the time being, inflation is kept at bay despite a ferentic printing press in America to fund stimulus and bailout packages, but I am cherishing the effects of deflation because in 2-3 years time, we will be begging for falling prices.

In the past year alone, US ramped up its money supply by $1 trillion which is likely to cause about 50% hike in prices as the money trickles down the food chain. This staggering amount, expected to be replicated for several years as bailout, spending and payment obligations pile up, will lead to hyperinflation and weaken the investment of foreign creditors.

The reserve currency status of the US Dollar is at risk. In good times, the US can deflate its debts by paying back money with lower purchasing power but with its economy in distress (insolvent households, banks and corporations), investors are not biting the bait anymore.

Calls for a replacement grow louder every day but this is no conspiracy, just simple economics at play. The situation today is markedly different as compared to 1948 when Americas was in ascendancy as the world’s biggest creditor and manufacturer and the owner of the largest gold hoard.

The US dollar was as good as gold, backed by a stable government, competitive economy and powerful military. Right now, save for a military which stills evokes fear and respect, its economy is in tatters and the government debt load is insurmountable.

It is entirely possible that under the astronomical Quantitative Easing policy, the US will suffer a double whammy of higher inflation without any improvement in its economy. Handing out the pork barrel to zombie banks and corporations means mistakes and weakness are not flushed out of the system. This is not the scary part, if you consider the multitude of bailouts awaiting the US government.

Indeed, the hat-in-hand circus is just getting started. The inability of individual states to meet their operating expenditures - at last count, 29 states anticipate budget deficits in 2011, will limit the Federal Reserve’s ammunition to cope with further shocks in the financial system. All it is needed is a precedent to set off a wave of state bailouts.

California is already making tough decisions, shutting down the civil service for three days and issuing IOUs. Other states may not have the luxury of borrowing and have to raise taxes, draw on reserves or depend on the federal government to prevent humanitarian disasters and economic standstill.

Yet, there are more bailouts to come. With more people jobless (on average for 6 months or more), America may have to bailout state trusts which pay unemployment benefits. Resources in unemployment funding are running low and may be insufficient to handle the next massive, post-holiday wave of layoffs.

And with just about everybody receiving some pork, you can’t leave a housing bailout out of the picture, nor a bailout of the pension benefit plans when employers go under. These are popular policies which directly affect the people on the ground and it is hard to say no, not when you have already bailed out greedy and irresponsible executives on Wall Street, compromised the federal budget and yet ignored hardworking Americans who are displaced from their jobs.

It is hard for the US government to put a stop to all these nonsense. Each bailout increases the pressure to fund the next one and the result is everyone ends up poorer. Noah’s ark can only accommodate so many living beings, trying to rescue everybody means you sink the ship. And this is what you get when the currency is debased. If the US Dollar is forsaken tomorrow, a significant devaluation will occur, followed by a huge loss in US denominated wealth.

China, Russia and India are now striking out similar paths to ween off their dependency on the dollar. At the very least, they are more concerned with their own domestic market than to think about funding America’s deficits.

The Chinese will not aggressively undermine the US dollar to protect their colossal foreign reserves in Treasury bonds but they are not standing still to witness the debauchery of the dollar via trillions of dollars in new debt. They will rather stake their claim on commodities by investing in mining companies and importing materials.

All the bailouts and lack of foreign participation will only force further monetization of Treasury debts but this is a dangerous and unsustainable path. Confidence in US dollar will return only if the monumental debts are whittled down or the money are channeled into productive economic activity instead of sheer speculation. But when nobody seems to be in the least interested in where or how the money is being used, you do have to wonder if Obama’s vision of change is for the better or worse.

With all the money printing to save America’s hide and destroying everybody’s wealth, what is an investor to do? Putting our cash under the mattress without any returns and assuming the same inflation from 1988 to 2008, our purchasing power could be halved in this 30 year period. If you factor in hyperinflation, then we could be left with a serious retirement crisis using that approach.

We definitely have to put our money to use. Inaction is not an option. To invest safely, it is important to do a thorough analysis of earnings report and a good measure of common sense. But the macro picture will affect us despite our best efforts to protect our money.

What I see right now is not a pretty sight. Like it or not, the fiscal malaise in America is also the world’s problem. That is, until a new global order is established. But that could mean everybody starts off afresh and nobody knows who owes what to anybody anymore. Is it good or bad, I do not know.

At the moment, I am staying off equities as trading in this bearish market calls for nimbleness and is a different ball game to the easy money during the bullish period from March to June. The risk return is not appealing but staying out entirely is not wise either as we could miss out on profits from sudden run-ups as well as steady dividends.

I have taken some profits off the table and my portfolio allocation stands at about 40% stocks, 15% gold and 45% cash. As I will investing more of my income into gold, I expect the percentage of equities in my portfolio to decline further in the coming months.

The precious metals sector is still in a favorable technical and fundamental situation, despite summer doldrums and the gold sale by IMF. I can’t say the same for commodities which have been driven up stockpiling in China and speculation by hedge funds. A correction is imminent once China feels it has enough commodities.

I expect more US bailouts to dampen market sentiment. Investors can choose to scale in progressively on the dips or just sit on cash. If there is no major correction, I will like the stock market to consolidate further as it accumulates energy for a sustained run. The longer idle cash sits, the stronger will be the pent-up demand when the market resumes its bullish direction.

Jun

21

Buy Gold To Keep Up With Inflation

June 21, 2009 | 7 Comments

During the recent stock market rally, it was easy for investors to get complacent about the future and engage in reckless speculation. The common refrain is that there is nothing much to fear except fear itself. After all, esteemed economics professors, including Paul Krugman, have ascertained that the worst is over.

Nevertheless, in the short term, the stock market rally is almost done. Window-dressing and opportunistic trading aside, we can expect a consolidation or downward correction. If you are sitting on cash, well, liquidity never hurts. If you are vested in blue-chips and getting attractive dividends, just maintain the status quo. 

I won’t be looking at stocks for a while. Inaction is a decision too when it comes to safe investing. Of course, you can always add to your portoflio if you are a long-term investor. For the time being, I am keen to accumulate gold. We may still be in a deflationary environment but the impending inflation from all the printed money is no laughing matter.

As it is, we are damned if we store our cash under the mattress and damned if we don’t. Think of inflation as a silent tax which eats away at our wealth which have been accumulated painstakingly from investments and savings. The same amount of money will purchase lesser goods in future.

The Federal Reserve has lighted the fuse of hyperinflation with its intervention in the Treasury bonds market. While its Quantitative Easing through buying debt with printed money achieved a shock and awe effect in March, this weapon to control interest rates has become blunt after repeated use. Long term interest rates will find its own level according to supply and demand, not artificial intervention.

In fairness, the Fed has little choice but to intervene because if nobody wants to buy US debts, then interest rates have to rise to attract investors. The cost of borrowing will increase and add to the ballooning deficits. Thus, inflation is deemed the lesser of two evils especially when there are still strong deflationary pressures to counter.

Whether monetization of debt is indeed the best option for the Fed may be debatable but one thing is clear, it doesn’t generate real wealth. All these money created out of thin air only serves to transfer wealth from solvent savers to insolvent debtors who are greedy and irresponsible. This redistribution of money from current taxpayers (and our future generations) is tantamount to looting but because it is done subtly, public outrage is manageable.

Thanks to decades of over-consumption (fed by easy credit) and an entitlement mentality, America is in a rut hole and currently experiencing a harsh deleveraging process. Being a keen student of the Great Depression, Ben Bernanke is determined to get credit flowing again, induce more consumption and stabilize asset prices. And America is not alone, all over the world, trillions of dollars are being spent to reflate the economy.

The problem is these governments are in debts, and can only finance their massive stimulus programs, bail-outs and loans guarantees by borrowing and money-printing. I am not against Keynesian policies but there is a fine line between starting a bonfire and a forest fire to stay warm. Saving all the too-big-to-fail institutions will eventually put nations at risk of defaults.

The latest figures show that the US has racked up fiscal deficits at 13% of GDP in 2009. Timothy Geithner’s promise to the Chinese that the US will keep its deficits to within 3% of GDP was met with derision. Clearly, nobody is taking his commitment seriously. US federal debt stands at nearly $13 trillion, almost equivalent to 2008 GDP, and that is not including obligations to Medicare and social security.

The US is so deeply entrenched in debt (it will be deemed insolvent long ago if it was a business), it will take a lot of time and political will to sort out the mess as well as to encouraging Americans to live within their means.

Because of the sheer size and the lack of fiscal discipline, there is little hope of US ever repaying its debts. Its current modus operandi is to roll over the principal and interest by issuing new bonds, at the expense of more debts. When US debts lose its allure, the house of cards will collapse, similar to the last stages of a Ponzi scheme.

Ponzi schemes survive by robbing Peter to pay Paul, thus, a constant influx of investors is needed to provide impressive returns to existing investors. If no more suckers come in, the game is over. Though the US government is big enough to guarantee US Treasuries, but with so much “risk-free” goodies being issued, investors must be wondering where is the breaking point, leaving them with worthless paper assets.

The crumbling of the mighty United States of America is akin to Britain after WWII when she gave up her empire and her currency collapsed. To peep at the future of America, one has only to study the “fiscal meltdown” of California due to a budget shortfall. Top state officials have pleaded Obama administration for emergency aid but to no avail. The worry is that a bailout of California would set off a dangerous precedent and other states may make similar demands.

California needs deep budgetary cuts to balance the books but this may worsen the state’s recession - unemployment figures will spike and housing market decline further. California is the 8th largest economy and its slump will be detrimental to America and global economic recovery. Of course, California may eventually be saved by the federal administration and all will be well.

But what happens if the United States is the one now facing the fiscal crisis? No institution is big enough to rescue them and unlike a business, you can’t force it into bankruptcy and auction off its assets. Not unless you want to risk a war with America. Thus, it is more likely that another Bretton Woods style conference to write down debts and devalue all nations’ currencies may follow.

I am increasingly skeptical about the viability of paper money as a store of value, especially the US dollar. You can feel the uneasy truce in the dollar’s status as the world’s reserve currency when the Russian Finance Ministry had to issue two conflicting reports in a matter of hours on their confidence in the greenback. Not reassuring at all.

In public, the three largest creditors of US debts, China, Japan and Russia will maintain that the US dollar is crucial and hope that the US economy is back in the pink of health. A weak US dollar does no good to export nations and reduces the worth of their investments in US debts. The currency in which trade is settled still remains dominantly U.S. dollars. And we don’t need any disruption in trade now. But away from the public scrutiny, US Treasuries are being dumped in exchange for commodities. At the very least, you won’t find any more buying frenzy in the US Treasuries.

If you are talking about safe investing, gold and silver should really be in our portfolio. With the amount of paper money in circulation (and more coming up off the printing machines), a tiny fraction of fiat currencies is enough to bid up prices of precious metals. Even though gold has fallen recently, it is an adjustment from overbought levels.

To date, about 160,000 tons of gold has been mined from the ground and at US$950 per ounce, it is worth US$4.9 trillion. But with at least US$60 trillion of paper money in circulation (currencies, savings, deposits, money-markets and CDs), gold is grossly undervalued.

It is prudent for investors to allocate 15%-25% of their portfolio to gold bullion, gold mining stocks, etc. Over the next weeks, gold may dip further and I see it as a good opportunity to accumulate gold. Buy gold to keep up with inflation and think about profit later. As far as I am concerned, that is the best safe investing advice.

More on this topic (What's this?)
Gold Stocks: How to Retire Early With Gold Dividend Stocks (Learn Mining News, 7/25/10)
How Jim Rogers Invests In Gold (Learn Mining News, 7/14/10)
Embrace the Sell-Off in Gold (Expected Returns, 7/27/10)
Read more on Gold, Inflation at Wikinvest

Jun

9

Limited Investing Opportunities In Range Bound Trading

June 9, 2009 | Leave a Comment

Time flies when we are having fun… we are now into the 13th week of a stock market rally that started in March. The embers of the stock market rally has not flickered out entirely but there are signs of investors taking some profits off the table.

In the short term, stocks may still rise. Blue chips have retreated slightly but are generally holding up while rotation plays have seen penny stocks enjoying a new lease of life. Some of the penny stocks have dubious fundamentals but this indicates investors’ appetite for quick gambles before getting up from their seats in the casino.

I have constantly stressed on a major stock market correction because I am not convinced that global economies will experience a V-shaped recovery. Yes, the worst may be behind us, as vouched by Paul Krugman.

He said: “I will not be surprised to see world trade stabilize, world industrial production stabilize and start to grow two months from now. I would not be surprised to see flat to positive GDP growth in the United States in the second half of the year.”

Before we get carried away, he tempered his optimism with another remark: “In some sense we may be past the worst but there is a big difference between stabilizing and actually making up the lost ground.” That implies we may not see full employment nor optimal production and consumption any time soon.

The harsh reality remains that employment, retail sales and auto sales are dismal. Non farm payrolls shows the smallest decline since October 2008 but the unemployment rate was worse than anticipated. Consumer spending, which powers two-thirds of the U.S. economy, dipped while consumer borrowing in April fell by twice as much as analysts had expected.

For the time being, bears have not asserted their full presence and range bound trading will be the order of the day. In the event of any drastic correction, the stock market has a tendency to fall slowly and then all at once. However, it is impossible to predict the timing of this reversal or what event will percipitate the downfall.

It could come from the energy sector which has been leading the market rally. Despite Goldman Sachs forecast of $85 price levels by year-end, actual demand in energy has not spiked tremendously. Hence, when the music stops for this fund-driven commodities run, things can get ugly like the collapse of oil trader Semgroup last year.

Or the tremors may emanate again from the financial sector. It has yet to discharge the first batch of toxic assets from the subprime crisis (saved only by the abolition of mark to market accounting) but could already be gearing up for the next lot of toxic waste from commerical loans, defaults of prime borrowers (people with sound credit and conservative, fixed rate mortages) who now comprise the largest share of new foreclosures in the 1st quarter, credit card delinquencies, and the possible unravelling of the $640 trillion OTC derivatives market.

Rising interest rates, Treasury bond yields and the demise of the US dollar are also factors which can cause irrational behavior in Mr Market. And, not to discount the highly unlikely but nevertheless possible mother of all crisis, a bailout of the US Treasury which has been heaped with the irresponsiblity of the financial sector. Its troubes could dwarf the collective collapse of AIG, Lehman Brothers and General Motors.

The US dollar is a sign of investors’ confidence in the US economy. While America still retains its status as being the most economically competitive country in the world, investors are growing jittery about the size of US deficits - ballooned further by stimulus and bailouts. At some point, not even America’s innovation, political stability or military superiority can prop the dollar’s value.

Ben Bernanke was astute enough to note that US cannot “borrow indefinitely” but he did not have a ready solution. Since “quantitative easing” (money printing) became fashionable in the Federal Reserve’s diction, Ben Bernanke had enjoyed a few early victories.

Initially, the monetization of debt (snapping up U.S. Treasury bonds which foreign creditors did not purchase) was successful in boosting Treasury bond prices and containing interest rates on medium and long-term U.S. bonds.

However, the buying spree could not prevent T-bonds from returning to its equilibrium - plunging prices and surging interest rates. The Fed has also poured half a trillion dollars to purchase mortgage-backed securities but mortgage prices are not on the mend and rates have still surged.

Success is limited because the Fed must print money to buy T-bonds. But the more dollars printed, the greater the inflationary pressure which prompt bond holders to ask for higher rates since they will be paid back in cheaper dollars.

Clearly, the T-bonds market could do without the Fed intervention as it results only in more investor selling. The corrresponding increase in interest rates could undermine stimulus packages and threaten nascent recovery in the housing market. Creating artificial demand is self-defeating and the US has little choice but to cajole, entice, threaten the Chinese or international investors to buy its T-bonds.

However, even if there is no love lost for the US dollar, until another reserve currency has been established, its current weakness has ramifications for the wider economy - commodity prices are being driven up which worsen the panic over inflation. People are worried about their declining cash value and buying assets which they don’t need.

We have to remember that amid green shoots and a “satisfactory” bank stress test, part of the current stock market rally was sparked by a fear of inflation. That is not a good thing. I mean, just look at the Zimbabwee stock market. The key Zimbabwe Industrials Index trekked up nearly 600% and 12,000% in twelve months.

You will have easily trumped Warren Buffett’s achievements but when you cash out your stocks in Zimbabwe currency, you realise all the capital gain is illusory. Zimbabwe economy is crumbling which shows clearly that stock market advances driven by inflation fears does nothing for the economy in terms of creating jobs, production or private investments.

I will rather see the stock market consolidating than to rise because market participants have no choice but to jump in because the US is frantically printing money to pay its debts while debasing its taxpayers’ and other nations’ savings.

The Federal Reserve is toeing a very fine line in maintaining a Goldilocks environment (not too cold and not too hot). It has to constantly tweak its monetary policy to adjust to new circumstances and making mistakes are increasingly costly. And the worry is that the weapons in its arsenal are dwindling.

In the current range bound trading climate, there are very few value investments available. Price-earnings are not attractive and there is little inclination to add on to positions unless second quarter results bring more cheer. This time though, investors will be looking for solid results instead of semi-bad news.

At the moment, a whole gamut of emotions (indecision, uncertainty, volatility, anxiety) run wild in the stock market. Any forays must be made on a short term basis. While I have taken some profits off the table and awaiting the next opportunity to enter the stock market, I am still holding on to substantial portions of my long term stocks which offer solid dividends.