Asian Monetary Sluices Opening?

Seems so.

Two events of potentially profound significance are now in train. On September 29th, China's new sovereign wealth fund, China Investment Corp., commenced operations. This fund is initially capitalized at $200 billion.
On Monday, the Japanese Post Office will be privatized. This institution constitutes the world's single largest pool of savings -- $3 trillion. This privatization will actually occur over a 10-year period, with the first stage beginning on Monday.

These two events signal the beginning of a major asset re-allocation. Heretofore, all these funds were invested in government securities, or used to finance massive public works expenditures. Going forward, an increasing portion of them will seek more lucrative homes. Likely residences: equities, real estate, participation in hedge funds, private equity, leveraged deals. While both the Chinese and Japanese authorities are hewing to the line that safety will be the primary consideration, with capital appreciation secondary, even this constitutes a notable change from the past, where there was only one objective: safety.

Our guess is that both China and Japan are looking at the performance of American university endowment funds for inspiration. Since departing from the conservative standards of the past, which mandated that endowment funds be invested in relatively "safe" investments -- high quality bonds and blue chip U.S. stocks -- many of these funds have wracked up impressive returns. Of course, these returns have been achieved by accepting risk greater, by orders of magnitude, than those deemed prudent in the past. Thus far, the gamble has paid off, though there is no assurance that this new financial mantra will not end in tears.

Institutional investors, like individual investors, tend to move toward greater risk as markets rise and as PAST RETURNS accelerate. In this regard, we do not expect sovereign funds or the Japanese Post Office to behave any differently. While paying lip-service to "safety" the practice will likely be to take on ever more risk, as greed overwhelms fear, and frustration over low returns from government bonds becomes intolerable. This is the normal progression; it ends only when there is a crash (a la the mortgage-backed collapse).

For the near-intermediate future, the decisions of China and Japan mean more liquidity for equity markets, reinforcing the bull run in U.S. equities. The attractiveness of American equities, which combine compelling valuations with low risk and high human capital, is further enhanced by the falling dollar,which allows Chinese and Japanese investors to purchase more U.S. shares with the same number of yuan or yen.

Mispricing of Emerging Markets

Our concern about what we view as the overvaluation of "emerging equity markets" -- particularly the China and Russian markets, but, to a lesser extent, Brazil and other markets -- is based upon more than a comparison of price/earnings ratios relative to those sported by markets in developed countries and historical ratios within each individual market. Certainly, the very elevated price level in China and Russia, relative to their own historical valuation ranges and relative to valuation levels in the U.S. and European markets is, in and of itself, a warning signal. However, there is more, much more.

The World Bank has completed a study of the sources of national wealth and worker productivity. Its conclusions are rather startling -- although they certainly pass the common sense test. The bank has concluded that "intangible" factors -- such as the level of trust among people in a society, an efficient judicial system, clear property rights, and effective government constitute the INTANGIBLE CAPITAL which comprises the largest share of wealth in virtually all countries. The bank concludes that only 20% of the wealth of rich countries, and 40% of the wealth of poor countries, are comprised of the sum of nonrenewable natural resources and produced capital (machinery, equipment,infrastructure, urban land). In other words, 80% of the wealth in developed countries, and 60% of the wealth of poor countries is in intangible factors which determine the levels of worker productivity and,hence, economic output.

In light of these findings, investment decisions -- whether direct investment or portfolio investment -- should place heavy weight upon the quality of the institutions which support economic activity in each country where investment is under consideration, and where true valuations -- in contradistinction to arithmetic valuations and seat of the pants ("great future growth in this country," etc. etc.)judgments about where future population sizes, natural resource endowment, and mathematically calculated growth will lead. Assessing future growth therefore depends upon assessing the current trends and likely future development of quality among institutions and practices of each country.

Considered in this context, the growth prospects, and hence investing attractiveness of some of the principal destinations of capital today seem to need serious rethinking. It is rather obvious that Russia is in bad shape. Its prospects for institutional and behavioral development along the desired lines seem poor. When these considerations are placed in appropriate perspective, Russian stock prices are OVERVALUED by orders of magnitude not implied by a simple arithmetic calculus of comparative valuation and assumptions of future growth. The same is true for China. The gap between price and real value is much wider than the substantial gap suggested by arithmetic comparisons alone.

Investors, it seems to us, would be wise to recalibrate their valuation processes by factoring in the decisively important institutional and social factors which have such profound importance for future economic productivity.

Russia/China: Robber Barons or Robber Bureaucrats?

The BRIC countries (Brazil, Russia, India, China) have become a great investment favorite in recent years. These are major countries with great potential for economic growth. In each case, there has been a partial dismantling of the prior statist economic systems. In the case of the former Communist countries -- Russia and China -- economic stagnation was directly attributable to a COMMAND ECONOMY, whose hallmarks were centralization of economic decision-making, prohibition of private profit, refusal to countenance entrepreneurial behavior, refusal to accommodate foreign investment, the lack of a reliable statutory regime to protect private and foreign investment, and, above all, TOTAL HOSTILITY TO MARKET PRICING in favor of pricing and resource allocation decisions being placed in the hands of a central state, but party-dominated bureaucracy.

In short, these systems were close to perfect ECONOMIC IRRATIONALITY. The complete failure of this anti-market system was inevitable.

The question is: has what has replaced these Command Economies laid a solid foundation for the durable economic growth which the current level of stock prices in these countries reflects?

Wall Street's near-unbridled enthusiasm for these two economies, and for both real and portfolio investment, seriously downplays certain disconcerting realities. Supporters of the Wall Street hypothesis airily reiterate that a true market economy will inevitably evolve. Along with this market economy will come political democracy. These iterations do not go beyond the level of mere assertion, however.

The initial stage of capitalism in the major western countries has as its hallmark the unbridled search for and accumulation of wealth by clever, hardhearted individuals who possessed the foresight to anticipate and exploit the future economic potential of new technologies. These individuals, who knew no ethical, moral, or religious bounds succeeded in accumulating great wealth. These agglomerations of wealth were then employed in part to finance more emerging technologies, and to create the means to harness them to new, profit-making enterprises. This in turn produced the next wave of wealth, innovation, capitalization upon that innovation, and the accumulation of even larger concentrations of capital.

A crucial ENABLING FACTOR in this process was the weakness or corruption of government. The losers in this economic process were politically incapacitated; thus they suffered without finding relief from government. This then was the Golden Age of the Robber Barons, who took everything within their grasp -- and then some.

This "immature" capitalism produced crises, which in turn created a powerful popular backlash. In the "democratic" western countries where capitalism developed most rapidly, these backlashes produced reforms which were essential to saving the market economy and its wealth creation machine--as well as the grossly unequal distribution of wealth and power. The motivation for reform -- to placate the demographic majority, make structural improvements in the system, and expand the developing mass consumption base of capitalism -- produced the modern MODIFIED WELFARE STATE and facilitated the emergence of a highly sophisticated, productive, and somewhat "kinder, gentler" market economy. The Robber Barons gave way to a new type of capitalist. This system has been generally satisfactory, especially in light of its obvious superiority to ALL OTHER ECONOMIC/POLITICAL systems ever attempted by humankind.

The question is: are China and Russia traveling along essentially the same path? Is their "immature" capitalism slated to mature? Will a modified welfare state, a regime of law and order, and a DURABLY PRODUCTIVE MARKET ECONOMY TRULY EMERGE? Or, alternatively, are these countries headed somewhere else?

There is a huge YELLOW LIGHT flashing, we believe. This cautionary signal derives from a FUNDAMENTAL DIFFERENCE between China/Russia today and America, Britain, France, and Germany in the 19th century. In the western countries there was extant a well-developed and long-established tradition of LAW. Private property and the sanctity of contracts were not only deeply entrenched, but were enforced by courts of law and governments which, though to some extent corrupt, were able to operate effectively to uphold those principles and practices essential to a strong market economy. It is a truism to say that dependability and regularity are necessary preconditions for business agreements and the effective functioning of a market economy, but it is a very important truism. The question is: do China and Russia measure up? And if not, can we reasonably infer that their evolution toward the desirable state is underway?

Our answer to both questions is NO. Political power in both countries is centralized in the hands of a very small number of individuals. These individuals exploit their political power to accumulate wealth for themselves, their families, and their hangers-on. This crony "capitalism" bears no relation to the real thing, in our view. While power was also concentrated in a small number of hands in the United States and other western countries during the "immature" phase of capitalism, it was acquired VIA SUCCESSFUL ENTREPRENEURIAL ACTIVITY. The capitalist risked his capital on the basis of his ability to make smart business decisions. In Russia/China today, there are no real entrepreneurs, except at lower levels of the system. Fortunes are acquired through obedience to the political center, rather than vice-versa. Fortunes are also lost -- ostensibly confiscated by the state, but basically stolen by the power-holders -- when the rich individual does not conform to the wishes of the power-holders.

Beyond this there is also the question of the identity of the power holders, and the skill set which enables them to acquire and retain power. These individuals are, in the case of Russia, primarily former senior officers of the secret police. Ascent through the KGB bureaucracy required the typical skills of the courtier: fawning subservience to the next higher echelon, mindless obedience, lack of any scruples, contempt for weak players, and a penchant for brutality. The Soviet system evolved from one dominated by the paranoia and brutality of a single psychopath (J.V. Stalin) to a government of self-seeking bureaucrats and secret police officers. This constitutes the governing class of Russia, and the source of wealth. We see here a situation which resembles that of many backward African dictatorships, where a corrupt elite siphons off the wealth of their country while the populace lives in squalor. There is NO EVOLUTION HERE toward political democracy or even toward a real market system. It is not price and productivity which allocate resources and wealth, but a corrupt elite.

In China, the situation is similar, with the difference that the power-holders are party bureaucrats, rather than ex-secret police officers. (There is, it should in all fairness be noted, more genuine entrepreneurial activity in China than in Russia).

Rather than evolving toward a functional market system these countries are headed in the direction of perpetuating dysfunctionalities in their economies. Foreign investment is NOT SECURE -- certainly not in Russia. The vast disparity in wealth and lifestyle between the favored few and the many is not narrowing, insofar as we can see. Nor is either state developing a modified welfare state apparatus to insure minimal income levels and to provide the safety net for the mass of potential consumers.

We do not believe that the Russian and Chinese equity markets are pricing in the great degree of risk which actually exists. This mispricing of risk is amplified by the extreme overvaluation of stock prices in these countries as measured by the normal yardsticks of stock valuation.

Technocrati Tags: Russia and China Investment

The Down Cycle in Interest Rates -- Part I (Market Rates)

09/23/2007

There are two elements worth considering in forming an assessment of the probable extent and duration of the current down-cycle in market interest rates. The first is an analysis of past short-cycle moves; the second is an assessment of the probable impact of the housing depression on the economy, rates of inflation, and market rates.

Before proceeding with this assessment, we wish to remind our readers that we ARE NOT HERE ADDRESSING THE ISSUE OF THE SECULAR TREND OF MARKET RATES. As we have pointed out earlier, the SECULAR DOWNTREND in market rates is now in its 26th YEAR. 26 years may seem like a long time, but if one places it into the perspective of secular moves over the past century, it is not actually all that long. It would be well to keep in mind that the PRECEDING SECULAR CYCLE OF RISING RATES lasted for 49 years. The yield on long-term Treasury paper was .10% in 1932; it rose from this low until 1981, when long-dated Treasury securities yielded in excess of 15%. While this does not assure that the current DOWN-CYCLE will endure for more years, it is a useful antidote for the endless noise created by financially illiterate literati who are forever proclaiming the end of the period of declining rates.

As a counter -weight to the endless din of speculation and "predictions" from sundry Wall Street gurus, FED "strategists," and their media outlets and amplifiers, who focus on when is the next cut (not too long ago all were focused on "when is the next increase," you may recall), we have reviewed the actual duration of short-cycle market rate moves. Generally, these cycles tend to last 2-3 years, give or take. The current down-cycle began in June 2007, when the yield on the 10-year note peaked in the 5.3% area, culminating in a 4-year uptrend in market rates (with the trough at just over 3% for the 10-year note in July 2003).

Based upon simple arithmetic (no over-hyped, over-sophisticated compute models or statistical analyses for us, thank you very much), we would expect the current down-cycle to last at least until early 2009. Of course, this will not be a straight progression. It never is.

As for the fundamentals affecting the extent and duration of the down-cycle, we will encapsulate our repeatedly expressed assessment -- the bear market in residential real estate in and of itself should suffice to produce a no-growth economy at best for a number of quarters, with inflation tailing off toward the 1% (PCE-core) area, if not lower. A serious deflation in the price of what is essentially the sole asset of most American families, and against which staggering household debt has been wracked up, cannot fail to have MAJOR CONSEQUENCES ON CONSUMER DEMAND, AND HENCE UPON PRICES. In this context, Fed actions are ALMOST IRRELEVANT. Market rates and a very broad range of prices are headed DOWN, DOWN, DOWN.

We will be assessing the probable course of the administered rate (i.e., the FED-controlled overnight rate) and its interaction with market rates and the overall economy in a future analysis.

China: Train Wreck Ahead?

09/22/2007

We will confess that we are as mesmerized by the spectacular growth of the Chinese economy as everyone else. It is indeed a remarkable performance.

Despite China's amazing growth rate, we have decided to emerge from our own trance and take a slightly closer look at this phenomenon. We are so motivated because we remember other Ten Feet Tall economies. Most recent in our remembrance is the Japanese economy. We will not forget that in the late 1980s, the Japanese economy was universally hailed as the Eighth Wonder of the World. The universality of this recognition, and the avalanche of accolades, occurred as Japan was cresting, naturally. And, as par for the course, Japan then DESCENDED, DESCENDED,DESCENDED. The glory of endless growth and profitability, of soaring equity and real estate prices, was COUNTER-TRANSMUTED into economic contraction, deflation, and asset value collapse, which saw the blue chip equity Nikkei index drop 80% from peak to trough and real estate prices drop IN EXCESS OF 90%. Even today, nearly 20 years after the Ten Feet Tall era, it is far from clear whether Japan has actually emerged from the seemingly endless deflation/depression.

China, of course, is not Japan. However, there are certain outcroppings of what normally portends financial market collapse. Generally, such collapse leads to economic troubles of massive proportions. While we are not necessarily predicting that this will occur in China in the near-future, caution is in order, we think.

The most obvious warning sign is the level of Chinese stock prices. While making due allowance for uncertainties in the accuracy of earnings reports and accounting practices, the following statistics are rather eye-opening:
--the benchmark Chinese stock index (CSI 300) sells at a reported 52x lagging earnings;
--the benchmark index has DOUBLED year-to-date

For comparative purposes, the Nikkei sold at 60x lagging earnings in December, 1989, when it stood at 39,000. Subsequently it fell to 8,000. This 80% decline certainly qualifies as "the mother of bear markets," to coin a phrase.

The U.S. market index sold at 15x lagging earnings in -- sorry about this -- the summer of 1929. It was for this reason that the eminent economist, Professor Irving Fisher of Yale University, proclaimed that "stock prices have reached a permanently high plateau." Of course, Fisher could not know that UNPRECEDEENTED AND INDEFENSIBLE FEDERAL RESERVE INCOMPETENCE would convert a mild economic slowdown into the greatest economic depression in American history, annihilating both earnings and stock prices.
In early 2000, at the high point for American stock prices and at the commencement of a 3-year bear market which brought the benchmark S&P 500 index down 50% (the worst decline since 1929-1932), American stocks sold at the UTTERLY UNPRECEDENTED LEVEL of 45x lagging earnings.

Our inference is: the Chinese stock market is INSANELY OVERVALUED, and is PRIMED for a SEVERE DECLINE. Time frame is UNKNOWN. Speed of decline is UNKNOWN. Distance from current stratospheric level to ultimate peak is UNKNOWN.

Clearly, the risk/reward ratio of the Chinese market has reached deep into LEMMINGLAND. No rational investor would buy Chinese stocks now; any holder would be prudent to significantly reduce exposure.

As for what might be the catalyst for a bear market in China, the answer is as plain as day: YE OLDE CENTRAL BANK RAISING INTEREST RATES. This process is well advanced in China. The PBOC (People's Bank of China) has repeatedly sought to tighten up, via raising interest rates and reserve requirements, and by imposing ever-greater restrictions of loans and investment.

The results: ZILCH. Consequently, with inflation rising to worrisome levels (China, unlike the U.S., DOES have a real inflation problem), the authorities have continued to pile one tightening move on another. These moves have individually been small and cautious, but cumulatively NOT INSIGNIFICANT. If there is a"law" of central bank behavior, it is this: the central bank will tighten until an asset price collapse begins. The more overbuilt the asset price structure, the greater the subsequent fall, and the smaller the ability of the central bank to brake the decline.

The Chinese authorities DO CONFRONT A GENUINE DILEMMA -- unlike our own central bank, whose dilemma is purely a public relations creation designed to allow the FED to pursue its own ideological objective in the face of contravening economic and political realities. The dilemma is this: the ruling Communist Party has deserted all of its ideological positions and today stands for nothing except holding power and milking its position for its own financial enrichment and familial advancement. Essentially, the Party, totally emptied of ideological commitment, is a clique of "ins," structurally very similar to ruling dictators and generals in innumerable countries, who grab up as much loot as possible while enriching families, friends, assorted hangers-on, and those instruments of repression which insure their perpetuation in power -- the military, the security forces, the media, the state bureaucracy.

The Party perceives that, without any ideological underpinning or real fealty from the populace, its hold on power is shaky. Moreover, in the context of rising expectations and rising popular DEMANDS for material goods, the PARTY must meet these demands if it is to rely on something other than sheer force to hold onto power and its LUCRATIVE benefits. A serious economic setback would place the party under serious threat.

The Party's difficulty is compounded by the contradiction between the growing role of the market economy, and the perceived necessity of maintaining key elements of the historical COMMAND ECONOMY of Communist China. This derives ultimately from the profound and unbridgable gap between the requirements of a true market economy -- which is THE PRIMARY SOURCE of China's economic miracle -- and the UNDEMOCRACY of the current "Communist" regime in China.

From the point of view of economic development, there are also certain historical "lessons" to consider. The evolution of western economies from undeveloped, rural economies to industrialized economies, and then sophisticated service-based information economies HAS BEEN PUNCTUATED BY PERIODIC MARKET PANICS AND ECONOMIC DEPRESSIONS. (D word, NOT R word).
Will China prove immune to this course of development?

Since we do not believe in fairy tales, our answer is a resounding NO.

Dollar Din

09/21/2007

The frenzy of dollar-bashing has reached a new peak in the last few days, in our impressionistic sense. This morning our local newspaper had, as its LEAD story on the FRONT PAGE, an article bringing DIRE TIDINGS of the DOLLAR'S PLUNGE. This article constitutes an apogee of sorts, we think, for the rising crescendo of DIRE WARNINGS about the grim fate of our currency.

We do not purport to be currency "experts," nor do we wish to prognosticate about the dollar's prospects. We do, however, offer a few observations based upon LONG, LONG observation of media excitement and its relationship to FUTURE TRENDS:
(1) The media -- including the most eminent and supposedly sagacious organs of information -- are generally at the VERY BOTTOM of the analytical food chain. Consequently, their pronunciamentos generally reflect WHAT HAS ALREADY HAPPENED, RATHER THAN WHAT HAS YET TO OCCUR;
(2)All other things being equal, the longer a trend has been in place, the closer it is to the point of reversal;
(3)If one considers the highlighting by the media of something as a DEVELOPING TREND, one can usually be fairly certain that the trend is long in the tooth and close to the point of reversal;
(4)Putting all this together, it is our view that acting on the basis of the "guidance" afforded by media highlighting is almost invariably a high risk/ low reward venture, at the very best;
(5)Taking it one step further, it may be wiser to regard the klaxon of screaming headlines and TV excitement over a "developing" trend as a signal TO POSITION ONESELF TO DO THE OPPOSITE.

As far as the fall of the dollar is concerned, we would note that it has been going on for awhile. Since markets tend to LOOK AHEAD, our gut feeling is that a great deal of the future economic slowing in this country has ALREADY BEEN PRICED INTO THE DOLLAR. We also wonder how the availability of cheap, high quality U.S. assets -- growing cheaper by the minute in currency translation terms -- will affect investment decisions among sophisticated managers of gargantuan pools of foreign capital (Middle Eastern and East Asian, in particular) looking for superior, SAFE investments in a globally low-yielding environment. Finally, it is hardly a secret that a falling dollar boosts exports and reduces imports, not only treating the undesirable huge trade deficit but implying strengthening export, manufacturing, and technology sectors down the road,with positive longer-term implications for growth in the American economy and an eventual rebound of our currency.

Lemming Maestro?

09/20/2007

Well folks, there is lots of buzzz this AM re. the vast opportunities supposedly afforded by the "emerging markets." (See our earlier blog, "Emerging Markets, Submerging Markets"). The initial Fed rate cut will supposedly generate a "bubble" in these markets; implicitly, according to the mass market sages, it's time to hop on board before the moonshot gets underway.

We hate to be party poopers, but we think it might be prudent to consider that the emerging market index HAS ALREADY RISEN nigh onto 500% over the past 5 or 6 years. We have gone from a situation where these markets were selling at a SUBSTANTIAL DISCOUNT to the U.S. equity market to the CURRENT situation, where many of them are selling at SIZABLE PREMIUMS to the U.S equity market. Moreover, U.S. stock prices have risen only a small fraction of the rise in foreign markets.

Why then should this be the time to buy foreign stocks? Why is it now de rigeur for EVERY INVESTOR to have an emerging market allocation in his/her portfolio? Where were Wall Steet's platinum-plated (or, should we say nickel-plated?) asset allocators five years ago, when emerging markets were ONE-FIFTH of what they are today?

The answer is clear. The farther up markets go, the farther they have yet to go.

JUST KIDDING! As those of you familiar with our thinking know, the EXACT OPPOSITE is the case.

Wall Street's perennial trumpet is now being sounded: "LEMMINGS! ALL ABOARD!" Yes, the time has come for the next over-the-cliff ride, we guess.

We are NOT saying that emerging markets will not rise further. After all, tek stocks rose -- and rose a lot -- during the second half of 1999 and the early months of 2000. However, we will all remember what transpired subsequently.

What we are saying is for those who have not yet thrown prudence to the wind, a calculus of the relative risk/reward ratios leaves no doubt about the most attractive area for investment: high quality U.S. growth stocks.