Wednesday, February 28, 2007

Al Gore

If you click on the title of this post, you will be taken to the website of Generation Investment Management. The Chairman of the firm is Al Gore.

Generation's investment philosophy incorporates sustainability issues into their investment process. I think that is admirable, as long as their investors are happy with their returns. However, I wonder how many people know that Al Gore is hyping global warming to the benefit of the companies in which Generation invests? Doesn't that sound like at least a little bit of a conflict of interest?

If I buy a stock and then post here wonderful things about it that I can't prove, without disclosing my ownership, I would find myself in a world of trouble with the SEC. Generation owns alternative energy companies that would benefit from any legislation that limits carbon based fuels and Al Gore travels around the world drumming up support for just this type of legislation. Hmmmm....

A Yen for a Correction

Why did the stock market sell off over 400 points yesterday? The standard explanation was the sharp correction of Chinese stocks which was caused (allegedly) by fears that the Chinese government would take measures to reduce speculation by locals on their exchange. Why would selling on the local Chinese market cause a worldwide selloff in stocks? The Chinese stock markets have a combined capitalization of about $350 billion. A couple of well heeled US private equity funds could LBO the whole thing. And the Chinese have about $2 trillion in savings so even a 10% plunge in prices shouldn't have that much of an effect on the Chinese economy. The selloff in world stocks was only partially related to the Chinese stock market fall.

The real culprit was the Japanese Yen. Huh? I haven't seen any news story yet that even mentions the move in the Yen yesterday, but that was the real cause of the selloff. Let me explain. Hedge funds have for many years executed a trading strategy called the carry trade. The funds borrow yen at a low interest rate (rates in Japan were just raised to 0.5%) and convert the yen to another currency where they can get a higher yield. Borrowing at a low rate and investing at a high rate means the trade has what is called positive carry. In other words, the yield on the investment more than offsets the interest cost from the loan. Once upon a time, the carry trade was primarily a bond trade. Borrow at 1% in Yen and buy Treasury notes with a yield of 5%. If the exchange rate stays the same, the fund makes the 4% difference. Leverage this up and you can generate high returns with seemingly low risk. The problem is that the exchange rate never stays the same. Over the last several years though as more and more funds have engaged in the trade, the very act of doing the trade caused the yen to fall which actually increases the profits of the funds who got in early.

Now funds have wandered away from the bond market with the carry trade. If you can make 4% buying Treasury notes, why not take the borrowed money and invest in the S&P 500 and make more? If you borrowed in yen last summer and put the money in US stocks you would be sitting on some big profits. These yen loans are now financing trades all over the world. Brazilian bonds, Turkish bonds, US stocks, Russian stocks and bonds, etc.

Here's the problem with the carry trade. If the yen starts to rise, the funds start to lose money as the cost of buying back the yen to repay the loan rises. And that is what happened yesterday. As the yen started to rise, the hedge funds took action to limit their losses. To do that they needed to buy yen which caused the yen to rise further which caused other funds to buy yen, pushing the yen higher which get the picture. To pay back the yen loans, the funds then needed to liquidate the investments they had bought with the loans. That would be the aforementioned bonds and stocks. And we get a 400 point loss in the Dow.

So here's the question. Did the funds start buying yen because they wanted to reduce their risk after the Chinese stock market fell? Or were the funds buying yen because they feared that other funds would buy yen to reduce their risk? It's a circular argument for which there is no answer, but one thing is certain. If the yen rises - for any reason - the pain will be felt a long way from Tokyo. I have talked for many years about the excess liquidity in the world financial system. The source for much of this liquidity is Japan and if it dries up the consequences for asset prices will be severe. I wonder if US politicians who believe a stronger yen would help the US economy by making our exports more competitive have any idea what the consequences would be if their desires came true? I suspect not.

I wrote our latest tactical update last Saturday and got it out to clients on Monday. The main theme was the need to reduce our equity exposure:

This past week felt like a turning point in the markets. I find it hard to explain why a seemingly uninteresting week with no major economic news felt so important, but I have learned, after many years of investing, to trust my instincts. And my instincts tell me that something changed this week....I have advocated an overweight position in stocks since our first tactical update in August, but the time has come to make a change. During most of this rally the average investor has remained skeptical. When I wrote that first tactical update back in August, the surveys showed more bears than bulls. As the market has risen, the number of bulls has increased steadily; as the market has rallied, more and more investors have jumped on the bandwagon. This week for the first time, bulls represented more than 50% of the survey participants. And that alone warrants at least a minor change. I am reducing our overweight position in stocks. I am still recommending an overweight but reducing our exposure to a more comfortable level.

I was able to get some selling done prior to yesterday's big selloff, but frankly I wasn't able to do everything I planned. Timing is everything in this business and while I'm proud of the call to sell some stocks, I can't help but think that I waited a little too long. One thing for sure; no client should have been surprised by the selloff. We have been talking about the likelihood of a correction since early in the year. In fact, we've been hoping for some kind of correction so we can put some money to work, but this was a little too much too soon. Oh well; you take what the market gives you.

The market will probably try to make some kind of rebound over the next couple of weeks. I doubt it will make new highs though and a retest of the low yesterday would be routine. I will probably be looking to do some selling on the rebound and save my ammunition for the next downdraft. That's the plan anyway. Let's hope my timing is a little better this time.

Tuesday, February 20, 2007

Iraqis Learn Nothing

The current Iraqi government is hard at work trying to emulate all those other states who have nationalized their oil industry. Too bad. As indicated below, the Iranians and Venezuelans haven't had a lot of luck with that central planning thing. Nevertheless, the Iraqis seem headed down the same sad path:

In its current form, the legislation envisions the re-creation of an Iraqi state oil company, and it gives broad latitude to officials from the country's various regions to encourage foreign investment and development.

Here's an oil worker's union official:

"History will not forgive those who play recklessly with our wealth," he said. "We consider the new law unbalanced and incoherent with the hopes of those who work in the oil industry. It has been drafted in a great rush in harsh circumstances."

What exactly does he mean by "our wealth"?

The rhetoric echoes the sentiment of many everyday Iraqi citizens. The nationalization of the Iraqi oil industry in the 1970s under Saddam Hussein remains a point of pride for many Iraqis, and opposition still runs deep to any hint of foreign interference.

Why not form a company and distribute shares to every Iraqi citizen? If the oil truly belongs to the Iraqi people, why does the government get to decide how the wealth is distributed? Why does the government get to decide if foreign companies can do business in Iraq? Distributing shares could also go a long way toward solving the political problems. If every Iraqi owned shares in the company, there would not need to be a method for distributing oil revenues among the provinces. The violence in Iraq is about money and power, but primarily money from the oil sector. That needs to be removed as an obstacle to peace. The best way to do that is by distributing the wealth in the only truly fair way - private ownership for every Iraqi citizen.

Venezuela and Iran

Venezuela and Iran are providing a real world economics lesson to their citizens. Both these countries are command economies run by decree from on high rather than responding to market signals. And the results are just what economics predicts.

From the Miami Herald
CARACAS, Venezuela -- Meat cuts vanished from Venezuelan supermarkets this week, leaving only unsavory bits like chicken feet, while costly artificial sweeteners have increasingly replaced sugar, and many staples sell far above government-fixed prices.

President Hugo Chavez's administration blames the food supply problems on unscrupulous speculators, but industry officials say government price controls that strangle profits are responsible. Authorities on Wednesday raided a warehouse in Caracas and seized seven tons of sugar hoarded by vendors unwilling to market the inventory at the official price.

Hugo Chavez seems to believe that the laws of economics do not apply to him and his backwater of a country. But price controls always have the same effect - shortages. Chavez imposed price controls in an attempt to control inflation that is now officially pushing 17%. Unofficially, it is most likely a lot higher than that. That is an example of treating the symptom rather than the disease. The disease is excess money (bolivar) creation which when combined with controls to prevent capital flight causes people to react to protect their meager savings. If you can't convert bolivars to dollars (or some other currency) and your bolivars are worth less every day, the only thing to do is spend the money. And that feeds the inflation. With price controls pricing many goods at less than production cost, producers are unwilling to produce to fulfill the rising demand created by the capital controls. Thus shortages appear. Call it socialism or communism or whatever you want, but this is economic idiocy writ large.

Iran is also experiencing some shortages these days. Not suprisingly, the cause is the same. Iranians, sitting on top of some of the largest oil reserves in the world, have a shortage of fuel. There are two simple reasons for this. First, the actions of the mullahs over the last 28 years means that most multinational oil firms don't or can't do business in Iran. That wouldn't be a great problem if the Iranian economy were allowed to operate in a more market oriented fashion. But the need to maintain political control means the government must maintain economic control as well.

Second, the Iranian government subsidizes the price of gasoline. A subsidy has a similar effect to price controls. If you maintain the price lower than the market, demand will create shortages. It also creates smugglers:

From the Wall Street Journal
But an even bigger problem is the consumers themselves. That's because subsidies make energy practically free in Iran, discouraging any serious energy conservation. Gasoline, for example, costs about 40 cents a gallon at the pump. That's encouraged an explosion of use, as Iranians add new cars while continuing to use fuel-guzzling old models. It has also encouraged a brisk smuggling trade as Iranians buy millions of gallons of fuel at the subsidized price and truck them into neighboring Pakistan, Turkey, Afghanistan and Iraq for sale at market rates.

It is also interesting to note that oil production in Iran today is only about two thirds what it was when the mullahs took over. And they have to import gasoline to meet the demand they've created by subsidizing the price. They claim they need nuclear power to provide for future energy needs. What they need is an Amazon account so they can purchase a few copies of The Road to Serfdom or maybe Wealth of Nations.

Friday, February 09, 2007

They've Got Us by the...Assets

Recently a good friend voiced a slightly altered version of the above phrase during a discussion of the Chinese government preference for US dollars. No she didn’t use the plural form of a word defined by Webster’s as “a round object that is hit or thrown or kicked in games”. She’s not that kind of girl. She was referring to the Chinese accumulation of US Treasury and Agency debt, but it now appears that the Chinese government is looking to diversify beyond the fixed income asset class. The Chinese government is rumored to be forming an investment fund, called the National Foreign Exchange Investment Company, to invest in other asset classes. The fund will be used for mergers and acquisitions of overseas businesses, energy assets, and equities.

With holdings of $1 trillion in reserves, it seems logical that the Chinese will look to invest some of the $200 billion the fund is expected to be seeded with initially to buy the stock of US companies. Why sell dollars and drive down the value of the fixed income allocation? That might seem like good news for investors in US stocks, but it should also send a bit of a chill down the spine of every stockholder. What exactly are the Chinese up to? Are they just looking to diversify as any prudent investor would or are they after something else? Since I’m writing this, it should be obvious that I believe they have another agenda.

I don’t know if the Chinese government has a long term plan to dominate the world like some James Bond villain, but their mercantilist impulses have consequences for the US economy and sovereignty. The number of grandstanding, populist politicians demanding that the Chinese revalue their currency up against the dollar grows by the day. These economic ewoks believe our trade deficit with China will magically disappear if only the Chinese will allow the Yuan to appreciate. And everyone knows that the trade balance is the vital sign that signals economic health…right? Well, not exactly.

Since 1976, the US has run a trade deficit every single year. The only times we have seen an improvement in the trade balance is during recession. So if eliminating the trade deficit is the path to economic nirvana, we just need a really good recession and our problems will be over. And a recession, or worse, is exactly what we would get if the politicians have their way. Senators Schumer (D, NY) and Graham (R, SC) (economic idiocy is apparently the only area of true bipartisan agreement) have previously introduced a bill that would levy tariffs of 27.5% on Chinese goods unless the Chinese take steps to “correct” the undervalued Yuan. Somehow these two intellectual giants have determined the exact amount by which the Yuan is undervalued.

I find it highly unlikely that the Chinese would just accept such a high tariff barrier and they don’t have to. As my friend said, they have us by the….Treasuries. Enact tariffs and the likely Chinese response would be a fire sale of US dollar denominated bonds. And there are a lot of excess dollars in the world. Furthermore, the rise in the price of Chinese goods would not be a good thing for the US economy. In case Senators Schumer and Graham haven’t noticed, those flat screen TVs the Chinese manufacture get sold in places like Best Buy and Circuit City. What do the honorable gentlemen have against the pimply faced gadget geeks that work the aisles of Best Buy? What about US companies manufacturing in China? Do the politicians really believe that if we raise the Yuan, that these US companies will relocate all their manufacturing back to the good old USA? I’ve got news for them; a 27.5% increase in wages in China will not be nearly enough to equalize things from the perspective of a manufacturer.

And let’s just suppose that the Chinese are magnanimous and actually do revalue the Yuan. Would it have the effect that Schumer and Graham assume? I don’t think so. The Chinese are primarily assemblers of products and thus import the parts for the products they assemble. They also must import raw materials such as oil. So if the Yuan is revalued up, what would be the effect? Probably not much. Their input costs would go down thus increasing their profit margins and allowing them to absorb most of the presumed rise in price for the final goods sold here in the US. The economic effect would likely be negligible and the trade deficit would be little better than it is now. And the Chinese would have a stronger currency with which to buy US equities and other assets. I’m really having trouble finding a positive here.

So what are the Chinese doing? While we are distracted with Iraq and North Korea, they are waging a kind of stealth economic war against us. Our politicians are doing exactly what the Chinese want them to do. By demanding a rise in the Yuan, US politicians will provide the Chinese with additional purchasing power to gain the assets they need to further their leverage over the US economy. Add say $500 billion in equities to their Treasury holdings and they will have a measure of control over our economy with which everyone should be uncomfortable. If they decide to move on Taiwan, we’ll have a choice of economic suicide or letting the Chinese have their “renegade” province back. I suspect the American public will choose flat screen TVs over defending Taiwan.

The good news is that we don’t have to let this happen. We are in this situation because of our own policy mistakes, not because of the Chinese. The primary cause of the situation is a monetary policy that attempts to control $US money supply without acknowledging the existence of or the need to control asset inflation. Globalization has the effect of holding down US consumer inflation by importing cheap manufactured goods from, ironically, countries like China which have much lower wage costs. The Fed, seeing no consumer inflation, assumes that they have control over the global supply of dollars. The asset inflation that we see all around us is ignored. Greenspan spoke of the conundrum of low long term interest rates and Bernanke talks of a global savings glut. What they apparently won’t acknowledge is that the cause can be found by looking in the mirror. There is no global savings glut; there is a global US Dollar glut.

Lousy monetary policy has been exacerbated in recent years by equally lousy fiscal policy. Inflation affects politicians too. The excess supply of dollars allows us to spend billions in Iraq even while politicians compete to see who can try to stuff the budget with the most egregious pork barrel project. Tax receipts rise as capital gains are realized from the asset inflation and spending rises even faster. I guess the politicians believe that if the Chinese are willing to loan us the money, they should find a way to spend it.

The answer to ending the Chinese influence on our economy will not be found in simple policy prescriptions like currency devaluation and import tariffs. The solution is found in a monetary policy that anchors the dollar to a true price indicator (that includes asset prices) and a fiscal policy that supports growth while controlling government spending. Until that happens, the Chinese will continue to further their grip on our….assets.

Coming Next: In my next essay, I’ll discuss the asset inflation that is the result of the excessive money creation of the Central Banks of the world.