Dollar ‘Free Fall’

March 7th, 2008

Recent market action has forced me to interrupt my dissertation on asset bubbles and opportunities. I will pick this theme up again on Monday.

For now, I would like to comment on the collapse of the dollar.  Those who watch fundamentals (economic data, news, visibility, etc….) are selling the dollar due to the fat that all the data points on the US economy and the most leveraged asset on the planet – US real estate – is weaker and weaker with each passing day.  And, as one central banking governor after another here in the US steps to the international center stage and voices yet another opinion about the economy or the dollar’s future, creating confusion rather than certainty.  Concerning the latter first, the ‘movement’ around the world is toward transparency and the Fed under Dr. Bernanke has led the way on this issue.  Bernanke and Co. are to be lauded for that leadership … HOWEVER; perhaps enough is enough is enough.

The market may be telling us that the professional and non professional investment community now believe the Fed is simply too transparent; where voices within the Fed are too public; where too much information is now a detriment rather than a benefit.  Investors today are telling, with their action, that the world may have been a better place when ‘we’ still could believe that the man behind the curtain was the Great and Powerful Oz; that he hand the answers; that the Fed was in control; that they could, in fact, see better than we.  Perhaps seeing the sausage being made really does tend to make one ill?

Until recently, the Fed did not let us know about the inner debates at each FOMC meeting, other than with a very real delay of several years.  It seems bothersome, but the world functioned well.  The world longed for greater transparency, but monetary policy seemed to function nicely; the economy grew pleasantly; inflation reared its head from time to time, but on balance things worked well.  With the new world that the internet has ushered in with mass collaboration and networking – the Fed was sort of forced to be swifter in reporting its debates to the broad public so that rumors and innuendo could be put to rest quickly.  So, the Fed moved to release its minutes with a greatly shortened time frame … And then it moved again, and again and again to shorten the lag between the last FOMC meeting and the release of the minutes to mere weeks.  At the same time, the Chairman made it clear that the FOMC was a democracy in action, and that the regional Presidents as well as the Governors in Washington could speak openly and frankly to the public concerning their views on the economy and monetary policy.

As with all good things, however, too much can be ill-advised and we may now have arrived at the point where the Fed’s officials are too public for the ‘public at large.’  The individual Fed governors now publicly broadcast their disagreements to the world at large, which creates inconsistencies and confusion.  Inconsistencies and confusion are two things the global markets could use less of as the de-leveraging of ‘risky’ assets picks up pace.  It would seem, to the casual observer, that much of the dollar’s, most recent, weakness is a by-product of this confusion.  The ECB speaks with one, unified and very loud voice: that of Mr. Trichet and a very few of his closest advisors.  The Fed speak as a democratic Hydra, and therein may lie the problem.

The Phillippines…

March 7th, 2008

phillippines flag

The Philippines (along with India) has experienced huge changes in the past few years. For the first time in more than 15 years of visiting the Philippines, I get the impression that a broad, qualified, and hard working middle class is emerging, which was certainly absent during the years of crony capitalism under Ferdinand and Imelda Marcos. The glamorous Marcos clan, whose lifestyle was financed by its well orchestrated kleptocracy, knew how to court and befriend American presidents. Lee Kuan Yew, on the other hand, was until about 10 years ago a persona non grata at the American State Department and was constantly criticized for his undemocratic behavior!

One of the principal reasons for the enormous ongoing transformation in the Philippines is the improvement in communication technologies, which has permitted the outsourcing of all kinds of IT services to Manila. The Philippines is now one of the top three IT outsourcing centers in the world, and from what I’ve read, the outlook for further growth seems to be very promising. Moreover, because of the improved economic and social conditions, many Filipinos who formerly worked in other countries, and especially in the US, are now returning home, either to take up employment in the Philippines or retire there. (The same trend is apparent in India).

Still, not everything is rosy in the Philippines: the country’s infrastructure remains poor, although some improvement is noticeable. The political situation continues to be messy and would make the perfect script for a soap opera. Where else in the world would a country’s leader, when still in power (Joseph Estrada is now deposed and under house arrest), refuse in a paternity suit to provide blood for DNA testing on the grounds that if he gave blood whenever a paternity case was leveled against him he wouldn’t have any left to run the country? Or where else would the wife of a former president (Imelda Marcos) who had successfully defended herself against allegations about the family’s ill-gotten wealth sue a former crony of the president (Lucio Tan), claiming that some of his assets belonged to her family and were being held in trust by him on their behalf?

Aside from some nice beaches and the stunning rice terraces in the mountains near Banaue, there isn’t much to see in the Philippines. However, the casual lifestyle and the friendliness and tolerance of the people, make it a very pleasant place to visit.

The Philippine stock market is no longer a great bargain, having risen more than three-fold since its 2003 low and having recently become a favorite among foreign investors. However, following a correction, an entry point should present itself – since in dollar terms the market is still 20% below its 1997 peak. Moreover, I believe that the Philippine peso could continue to appreciate following a correction

Chasing Bubbles

March 7th, 2008

“Castles in the air cost a vast deal to keep up.”
- Edward Bulwer-Lytton

Until very recently, we’ve watched money flows move from one bubble to the next … This is how the ‘smart money’ has played the asset bubble environment since November 2001 when the Fed began to pursue ultra easy monetary policies. What tends to happen, as one bubble bursts, is that money flows into other assets markets that haven’t been inflated or were even deflated. I recall well the view in the late 1980s that when the Japanese equity and property bubble finally began to deflate, everything would be effected negatively because the bubble was of such gargantuan size. (At its peak, the market capitalization of Japan exceeded that of the US, UK and Germany combined). But that wasn’t the case. Money flowed out of Japan into other markets – notably into US and European stocks. Similarly, when the TMT bubble ended in March 2000, ‘old economy’ stocks and commodities began to move up. Granted, to the extent that we don’t find today as neglected an asset class as commodities and ‘old economy’ stocks were in 2000 (with the possible exception of US dollar cash), it is more difficult to make the case that, in an asset bubble scenario, one or another asset class will take the baton from today’s leaders and perform well.

Over the next few days, I will highlight some momentum-driven, but high risk markets, as well as some relatively inexpensive assets. I would like to emphasize that I don’t recommend playing the momentum markets unless you operate with very tight stops and have some serious experience as an astute trader. My inclination is to look for relatively depressed assets that would likely not collapse – totally – once the current asset bubble comes to an end. And by the way, the asset bubble came to a screeching halt on August 6th, 2007 as the global credit markets tightened.

To kick this series off in grand style, the credit bubble has begun to deflate … This portends very bad news for those assets that have been fueled by credit. The most levered asset in the world is that of US real estate. With the market tightening (borrowers and lenders becoming more insecure) we are seeing very little demand for debt. Regardless of the Fed’s action – without demand there is no credit. This is a real problem.

As noted above, over the next week, I will highlight a handful of asset classes that need to be avoided – and a few that need to be considered. As I wrap this series up, there is one asset class (market) that I have become very interested in and the time to ‘hit the bid’ has arrived.

Bubble #1

March 7th, 2008

Rarely has an asset class attracted so much attention as the Chinese stock market. However, whereas in previous bubbles the consensus was always that prices would move higher, in the case of the Chinese stock market the consensus is that it’s a giant bubble. Sure, valuations are extremely strethed, and the number of new accounts trading shares is soaring. According to Dong Tao of Credit Suisse,

There were 6.75 million new trading accounts opened in January alone, for A shares, B shares and mutual funds. That is more than the amount of new accounts opened for the entire Q 107, which is or than that during the entire period of 2005-2006. Stock turnover on both the Shanghai and Shenzhen Stock Exchanges reached $49 billion on May 9, more than the $43.4 billion for the entire Asia Pacific region, including Japan, Australia, and New Zealand.”

And according to David Webb, editor of the excellent www.webb-site.com, thee is something to consider … While we wait for the collapse of the mainland market bubble. How high will it go and how long will it be before it bursts? Nobody knows, and that’s what makes non-linear phenomena such as earthquakes, volcanoes, avalanches and market crashes so interesting. But it’s certainly time to issue an avalanche warning. Take a page out of Taiwan’s history book. Back on 10 February 1990, the TSE Weighted Stock Index peaked at 12,495. It then crashed 80% to a low of 2,560 that year. Taiwan was then a closed market with strict capital controls. Market turnover that year was 500% of market capitalization. Does any of this sound familiar?

According to Webb, stock market turnover in China is ‘currently running at about RMB300 billion per day, on a market cap of about RMB15 trillion, so say 2% per day, 240 days per year, that would be about 480%.’ Webb also notes that free float in China ‘is substantially less than 50%, so the real velocity is higher.’

So, all the symptoms of a gigantic bubble are there. However, mitigating the ‘Chinese Stock Market Bubble’ are the following factors. The stock market is up four fold since the summer of 2005. But, as was the case for the Indian stock market when it took off in 2003, after it had declined in dollar terms by 70% from its 1994 high. Chinese stocks in 2005 were not very expensive. The Shanghai stock market had declined by 60% from its high in 2001, while the economy had grown by 10% per year over the same period. In other words, if we don’t measure the increase in China share prices from their depressed 2005 lows but from an average level between 2000 and 2006, the rally, while still substantial, is not so uncommon in a world of asset bubbles. Don’t forget that, in previous asset bubbles, prices frequently moved up by between 10 and 20 times to their final highs (gold and silver in the 1970s, Taiwan between 1985-90, Latin American markets between 1988-94 and tech stocks in the 1990s, etc.). Moreover, if we compare Chinese GDP growth since 1992 to the performance of the stock market, it would appear that there is still some room for stocks to move higher. So, whereas, I agree that we are in the midst of a Chinese stock market bubble, the question is whether – compared to other assets – the Chinese bubble is really inflated. Take the recent Christie International postwar and contemporary auction in New York, which set a record by raising US$385 million, beating the previous high set a few days earlier by Sotheby’s by 50%. According to Bloomberg,

“… The market confounded predictions of overheating and extended its position as one of the fastest rising investments. Andy Warhol’s acid green painting ‘Green Car Crash’, which had a top estimate of $35 million, sold for $71.7 million. ‘Green Car Crash’ had last appeared at auction in 1978, when it fetched about $69,000 at Christies in London … Another Warhol, ‘Lemon Marilyn’, a portrait of Marilyn Monroe with a purple face on a yellow background, was estimated to fetch up to $18 million and sold for $28 million. It had been acquired by the seller for a few hundred dollars in 1962, the year it was painted …’

So, whereas I personally wouldn’t buy ‘Chinese stocks now’ (in fact, I’m selling them at the moment), believing that we are already in some kind of a bubble, I can see that the Chinese stock market could move still higher – possibly even double from here – both for the reasons outlined above and because people in China, real estate aside, don’t have many investment alternatives. Bank deposit rates are artificially low, and the Chinese bank deposits, at more than 120% of GDP, are if not the largest, then certainly among the largest in the world. Moreover, as pointed out above, foreigners are mostly bearish about Chinese equities …

This is the sort of thing that gets my attention. More tomorrow …

Asia’s Past, Present, and Future…

February 8th, 2008

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I was recently reminded by a reader that it may be nice to look closely at a few markets and economies that will have the wind at their backs over the next decade rather than spending much of our time on ‘hot button’ issues of the day that are symptoms of the current state of play in the global financial arena.  This point is very well taken.  I must admit, that I find myself writing about thoughts and ideas that race around in my head – it’s like I’m having a conversation with myself – aloud.

A few years ago I spent some time in Manila, in the Philippines.  The Zobel family, who control Ayala Corp and various other companies and financial institutions, had invited me to attend their annual strategy meeting.  I told the attendees that I was very familiar with their company, having worked closely with a confidante of Enrique Zobel (Enrique ran the Ayala Corp in 1972), for the better part of a decade in the 1990s.

Enrique, a tycoon in the style of the late Kerry Packer – rich and powerful, an accomplished sportsman, charismatic and daring – invited my partner to join him in Punta Baluarte (in 1973), a seaside resort he had developed near a large plantation he owned.  The story went something like this: Enrique picked him up in at the Intercontinental hotel in a convoy of three cars.  The first and last cars contained an army of bodyguards, all equipped with rifles.  Enrique was at the wheel of his jaguar, with another armed bodyguard sitting beside him.  As the convoy made its way to the airport to board Enrique’s private plane for the flight to Punta Baluarte – hundreds of plantation workers had assembled.  Chairs had been set out under umbrella to shield the sun … After everyone found a comfortable spot in the shade, the workers formed a long line and, one by one, they approached Don Enrique, kneeled before him, and kissed his hand.

When I told this story to the attendees of the Ayala meeting in Manila, everybody laughed.  Jaime Zobel, Ayala’s Chief Executive Officer, told me that things are quite different today, which is certainly true.  Like many other Philippine companies, Ayala is run very professionally and is entirely transparent, with excellent corporate governance in place.  Nevertheless, that day in 1973 had made a lasting impression on my partner.  Switzerland, where he grew up, is an extremely democratic country (even schoolteachers are elected) with an imbedded philosophy of social justice. Switzerland has never had a proper aristocracy, with lords and ladies, princes and princesses, barons, counts and so on.  In fact, Switzerland had much worse: the monasteries, which controlled – and still control – most of the land, and to whom people had to pay taxes in order to secure a spot in heaven.  (For some incomprehensible reason, Switzerland still has a ‘church tax’ which the Swiss can avoid paying if they request to leave the Church).

The reason I am writing today about the Philippines and the Ayala group is that Joe Studwell, who edits The China Economic Quarterly and wrote The China Dream (2005), has recently published a new book, Asian Godfathers: Money and Power in Hong Kong and South East Asia.  This profile of Asia’s billionaires explodes the myth that they were responsible for the region’s high economic growth.  According to Studwell, growth in Asia, and the region’s recovery after the Asian financial crisis, were driven by export industries, a business sector generally shunned by the tycoons because it involves international competition.  In fact, Studwell argues that “the godfathers have been much more the beneficiaries than the instigators of growth.”

I certainly commend Studwell for Asian Godfathers, in which he makes a number of pertinent observations.  I also hope that his kneecaps will remain intact.  However, it’s my opinion that Studwell hasn’t fully addressed the that fact that an enormous transformation has taken place in Asia since the 1970s and 1980s, when tycoons of the likes of Enrique Zobel, Lim Siew, Ronald Li, Ibnu Sutowo, Robin Lo, Lucio Tan, and Bob Hasan exerted a huge influence.  Today, most (I admit not all) businesses are run very professionally, with good corporate governance.  The offspring of the ‘godfathers’ have been mostly Western educated and understand that if their companies are transparent and clean, they will be rewarded with a much higher valuation in terms of P/E than if they install their relatives and mistresses in flower shops and boutiques leased at preferential rates from their publicly listed property companies – And while many Asian companies are still family controlled – Sung Hung Kai Properties, City Development, UOB, Genting, CP Food, Ayala, etc – they are very well managed even by international standards.  In the 1950s and 1960s, during the early stages of Asia’s economic miracle, wealth was created by entrepreneurs such as the Shanghai textile manufacturers and shipping magnates (Y.K. Pao and C.Y. Tung) who, after having been instigators of growth and competing very successfully internationally, may also have become beneficiaries of growth by branching out into property development.  Also, I’m not entirely sure how to distinguish an ‘instigator’ from a ‘beneficiary’ of growth.  Are tycoons such as Stanley Ho (casinos), and Henry Scy (retail) instigators or beneficiaries of growth?  Should hedge fund managers, private equity people, derivatives traders, real estate investors, art dealers, football team and restaurant owners, casino operators, and hotel and amusement park developers be considered instigators – the pioneer and innovator – and the beneficiary of economic development.

I should also like to mention that by far the most influential ‘godfather’ in Asia is no other than Lee Kuan Yew, who put Singapore on the world map by creating the highly successful growth company “Singapore Inc.”, a well diversified modern economy with a superb commercial and physical infrastructure and almost perfect security, and which always competed internationally.

The point is that Asia has, indeed, changed enormously over the past 30 years or so.  People like Richard Lawrence, who runs Overlook Investment, will surely agree with me that companies are increasingly realizing the merits of value creation by being shareholder-friendly.  Some – but not all – of this transformation of Asia’s economies and societies has been desirable.

During my next two missives, I will give you an overview of two Asian economies that garner very little international attention – but should be bought and held for the long haul.

More Fed Speak

February 8th, 2008

When reading the minutes of the last FOMC (Federal Open Market Committee) meeting I was struck by the fact that the Committee looked as closely at the oil futures market as it did, for their notes of the meeting made mention of the fact that the ‘forward’ futures contracts were pointing to materially lower prices out into the future. This is utterly and completely ridiculous and a dangerous assessment – as the futures markets (like all markets) are fractals – not linear beings. When I first noticed this statement – I ignored it; however, in reading his two day testimony before Congress, I felt compelled to stand up and say something … So here goes:

Yesterday, when queried about oil prices and the Fed’s view of the future and its effect upon inflation, Dr. Bernanke drew everyone’s attention to the fact that oil six months hence is trading at or near $90/barrel “on the futures” markets. He made the statement in order to argue that inflation will moderate. That is, however, the wrong view of the term structure of a carrying charge futures market. Most academicians make the same mistake when sizing up the futures markets … Why? Because Lord Keynes published an article in 1923, which still finds headlines, press and white papers today – detailing what he referred to as ‘backwardation’ of futures prices and that long side speculators were paid to accept the risks of ownership of various commodities by owning those discounted futures contracts out into the future. He said hat the hedgers ‘paid’ this price to the speculators, and that the speculators earned and expected this ‘backwardation’ return – that this was their reward earned for accepting risk. At first blush, this seems reasonable; even logical … Except that the futures markets were and still are rarely in ‘backwardation.’ Normal is a contango market, where the spot rate is below the nearby futures, which is itself discounted the next futures contract on the calendar, which is discounted to the next … And so on. In a contango term structure, hedgers are ‘paid’ to store a commodity, and are able to sell deferred futures at a premium, earning the ‘cost of carry.’

Professor Holbrook Working of the Stanford University Food Institute wrote a wonderful series of articles in the 30s and 40s that took Keynes’ thesis to task and in my opinion was correct. Working proved that the only contact of importance is the nearby futures, and that for grains, the market is ‘normally’ in contango. Hedgers … In this case grain elevators … Will accumulate grain, put it into storage, pay the price of the nearby futures + or – some difference known as the basis, and sell deferred futures if the deferred futures pay the elevator his costs of storage. Thus, if the cost to store corn from March to May is, for example, 5 cents, and if the May futures trade at more than 5 cents premium to March, the hedger will roll his short March futures into May and store the grain. The fact that May is at a premium to March does not speak to the notion that grain prices are expected to move higher; it speaks only to the notion that the borrowing, insurance and other ancillary costs of storage have been covered. The hedger is then an arbitrageur, holding or liquidating inventory as the carry charges dictate.

Markets can move to a backwardation when and only when demand outpaces supply. A backwardated market is simply the term structures way of forcing a storable commodity out of storage in order to meet rising demand. Indeed, it is a general rule among grain traders to ‘Never sell a backwardated market’, for the backwardation speaks loudly of strong demand.

Dr. Bernanke individually, and his staff economists collectively, misunderstands how the term structure functions. Looking out into the future and drawing the conclusion that the futures market is ‘forecasting’ lower energy costs is utterly wrong and shows the ineptness of Bernanke’s analysis. The price is backwardated because demand is strong and supplies are tight. What the 3rd, or 4th or 5th or 15th futures contract has to say about prices is non existent. Keynes was wrong; Working was right, and the Fed’s decision to see things in a Keynesian framework will lead to much more disastrous economic decisions that have significant consequences.

There, I’ve said it.