Book Review: "China shakes the world" by James Kynge

This is a very well-written book: easy to read, vivid, informative and thoughtful about future trends. James Kynge has spent 19 years in Asia, half of that reporting from China, latterly for the Financial Times. His direct experience may be the most valuable aspect: he gives a sense not only of what the Chinese are doing, but their motivation.

This is an interpretive, sequential and selective summary, and I do suggest you buy the book - US Amazon link here (hard cover), UK Amazon link here (paperback).

It opens with the widely-quoted narrative about moving a steelworks from Dortmund, Germany to the Yangtse delta in China. The Chinese labour much longer and with less regard for health and safety than their European counterparts, shifting the plant in a third of the time originally expected, together with many tons of paperwork (rapid transfer of know-how is a major theme).

The purchase of the works was completed equally quickly, at a time when the Germans suffered high taxes because of reunification, world steel demand was depressed, and South Korea was undercutting their prices. But Kynge notes that had the owners waited until 2004, the recovery in the market would have made the works profitable again, even in Dortmund. A battle lost through failures of nerve and foresight?

The new owner, self-made billionaire Shen Wenrong, had now bought himself a ready-made plant at scrap cost. This got him into production faster, but also with less debt, an advantage which will tell when the next downturn comes - which Shen expects to happen soon.

The Chinese economic reforms that started in 1978 have seen many rags-to-riches stories. The Party hadn't officially sanctioned private enterprise on such a scale, but local officials turned a blind eye for the usual reasons - corruption and ineffective central control are other motifs in this story.

China has leapt from village and farm to city and factory at warp speed. This means that there is a vast pool of eager, cheap labour for its new industry. There is also a great and growing demand for resources, not only for manufacture but also for city construction, road and rail development, and energy production.

The move from handwork to brainwork means education is very valuable - a later chapter gives an example of identity theft merely to secure a college place, which then helps the thief into white-collar work and a far higher standard of living. For the Chinese, elitism is the way to excellence; Kynge writes of a Shanghai school principal's amazement at Britain's assaults on selection in education. Chinese who can afford it are buying the best foreign private schooling - Dulwich College has opened subsidiaries in Thailand and China.

China has a huge population, with a per capita income of slightly over $1,000 a year. Although its people are racing to catch up with our living standards, demographics will impact on the economy: by 2040 one-third will be over 60 years of age. Kyng says, "It may be that China grows old before it is rich." Like Alice and the Red Queen, China has to run just to stay put - the country has to create 24 million new jobs each year, or face the social and political consequences of a stall.

So the pressure is on. Many companies have copied designs and technology e.g. from the Japanese, and then from each other, setting up rival concerns and increasing production to the point where the profit margin disappears. But the result is not bankruptcy - the government has decided that employment is more important than Western-style financial probity. Besides, there's lots of money available for commercial lending: Chinese people save around 40% of their incomes. Since the domestic market is oversupplied, the Chinese look to make a profit from exports, deflating the global market in manufactures.

Intellectual property rights are not a priority in this scramble. The author visits Yiwu, a great market for pirated goods, and when he calls the anti-fakes hotline he gets the runaround.

What about the quality originals? He visits Prato, Italy, to see the ancient textiles centre; it's been hit hard. First, Chinese arrived as cheap immigrant labourers; then Italian firms began to import materials from China; then they started to get the work itself done over there; finally, Chinese firms set up and took over, appropriating pattern books that took centuries to develop.

The tale is the same with silk, in Como, and jewellery, in Chiasso. "In many areas of manufacturing, European companies cannot compete in the longer run - no matter what counter measures they or the EU may take." White collar workers are not safe, either: their work is also migrating to India and China: "...accounting, law, financial and risk management, healthcare, information technology and several other service areas."

European workers cost too much: pay, healthcare, unions. And their governments are too expensive: Chinese state expenditure as a percentage of GDP is less than 50% of German levels. But European countries are democracies, so tough economic action is politically difficult; whereas in China, it was possible for them to lay off 25 million workers in state-owned enterprises in 1997-2002, and 120 million migrant workers receive no welfare at all.

To the USA: Rockford, Illinois, the centre for machine tools. The Chinese government is overwhelmingly composed of engineering graduates, and they want Western tools, blueprints and know-how. They bought Ingersoll Production Systems and used the firm to try to acquire Ingersoll Milling Machine, which has key technologies for rockets, nuclear power stations and stealth bombers. The US government and its intelligence services were quite unaware, until tipped off by locals. Now, American machinists who used to earn $16/17 per hour are working in retail for $7 per hour, with no pension.

Eric Anderberg of Dial Machine tells the author how the world is not flat, but tilted against America: China has an undervalued currency, little welfare for workers, no labour unions, cheap credit from the state banking system, loan defaults without consequences, VAT rebates available to exporters but not US companies, lax environmental emission controls, intellectual property theft and little enforcement of IPR rights, state-subsidised input costs such as electricity and water. And then US bureaucracy and legislation adds some 20% to American business costs.

Kynge learns all this at the local annual Chamber of Commerce dinner, where Al Frink, the US President’s manufacturing “czar”, is to speak. The dismayed audience then hears Frink talk in favour of outsourcing. The author notes that what hurts Anderberg suits the big US corporations, who earn 25% of their profits from foreign subsidiaries; for example, IPR theft saves on overseas R&D. Anderberg remarks that “Lenin said that America would tear itself apart from the inside through greed.”

Kynge turns back to a coal mining area in China, to illustrate her difficulties. Industrialisation is creating health-wrecking air and water pollution. There is a shortage of usable land, and the deserts are advancing. China is gobbling up resources and commodities, especially oil. There are environmental limits to growth: using the measure of a “green GDP”, i.e. economic growth minus resource depletion and environmental degradation, Shaanxi province has made virtually no progress in the last 20 years. Besides, China’s vast population can never have a standard of living like present-day America – the world does not have the resources.

The pressures are breaking down the bonds of mutual trust and obligation. Identity theft; bogus police; cash-stuffed envelopes for journalists; corrupt and immune officials; sexual infidelity; lethal, fake baby milk powder; HIV-infected blood plasma. And from the West's standpoint, there is an image of political oppression, unfair terms of trade, supposed worker exploitation.

So China has a brand image problem that affects its foreign trade. But if China can crack this, she will enjoy another great leap forward. For the worst exploitation of its workers is not by the Chinese themselves: "... all of the work done in China - the sourcing, manufacturing, transportation and export - rarely qualifies for a return of more than 10 or 15 per cent from a product's sales revenue." Most of the money is being made in advertising, marketing and sales., and when the foreign consumer no longer thinks it uncool to buy openly from the Chinese, the latter will reap much greater benefit from their labour. (Perhaps there are some questions to be asked about the markups and fees of Western middlemen.) We shall have to see how the Olympics changes perceptions. Meanwhile, established brands are being used as the marketing wrapper for Chinese work, e.g. Lenovo's purchase of IBM.

Doubts about China are not merely a matter of perception. The country is trying to move to a capitalist economy, but retain centralized Party control. So when companies get stockmarket listing, typically they float less than a third of share capital, keeping ultimate control for their own management. There are lax disclosure rules and company figures have not infrequently been falsified. The "big four" banks are State-owned, run by Party officials and burdened by bad debt. Kynge guesses it could cost up to $500 billion to clean up the financial system. There is also corruption - he gives as an example oil wells in Shaanxi, developed by private investors and then arbitrarily confiscated by local officials, who may well have benefited personally; but appeals to the local courts are pointless, since the judges are appointed and paid by the same officials. There is some hope: in March 2003, the national Constitution was amended to give private property the same status (in principle) as Party property - but government accountability is still in its infancy.

The author concludes with a chapter on China's relations with outsiders, which are coloured by the events of the nineteenth and twentieth centuries. The desire for economic progress is sometimes in conflict with impulses of national pride, power and prestige. Now that she is becoming mighty, China is choosing her own friends, and is in uneasy relationships with neighbours such as Taiwan and Japan. As America's balance of trade worsens, China may have more than one reason to give more weight to its own need for economic development than to harmonious foreign relations.

Why commodities are the future

Martin Hutchinson, writing in PrudentBear yesterday, explains why he thinks commodities are in a long-term bull market: the developing world wants the "white goods" and other consumer durables that we already have and take for granted.

Peter Schiff - corrosive effects of debt

Peter Schiff has revamped his site, and is generally increasing his media profile.

His economic commentary reports that the US has sent an official to China to ask them to buy into mortgage-backed securities! (The man will deserve a medal if he succeeds.) But it's not only subprime loans that are risky - Schiff says that many home valuations were inflated for mortgage purposes, and foreclosures realize less than half such values.

Turning to government debt, he says Treasury bonds will be hollowed out by a gradual devaluation of the dollar (by maybe 50% over the medium term), plus soaring interest rates. Further ahead, he sticks to his Crash Proof prediction of hyperinflation.

Future opportunities in the subprime market

Following on from the last post, I feel Mr Schultz could well be right, though the timing is important. There are going to be many people with an impaired credit history after this debacle, who want to have another go at owning their own home; and presumably houses will become more reasonably-priced, too. A specialist lender could get good returns from servicing carefully-selected customers, in much the same way that after a natural disaster, fresh insurance companies enter the market on a better footing, while the outfits that were already committed are still struggling.

As Wavy Gravy said at Woodstock, “There’s always a little bit of heaven in a disaster area.” Though of course, I'm sure he didn't mean it in quite that way.

Update

Having written that last bit, what do I read (in Saturday's Free New Mexican) but that some of the hippies who set up communes in New Mexico eventually became realtors!

US subprime fallout

Credit rating agencies seem on the brink of downgrading CDOs, according to last week's New York Times; GE has dumped its subprime portfolio, accepting $160 million losses; the Wall Street Journal reports on the exposure of mutual funds to subprime lending; Fannie Mae and Freddie Mac are getting choosier; official guidance is being issued to brokers; borrowers are starting to sue lenders; the dollar is dropping against the Euro, in advance of expected bad figures on consumer spending and borrowing; builders are quitting, going to law or offering special financing deals.

Among loan arrangers, 15,000 of 500,000 jobs (3%) have gone; Guardian Loan Company has escaped collapse by the skin of its teeth, because eager new firms were squeezing it out of the niche market and back towards standard mortgages - but like General MacArthur, chief executive Stuart Schultz promises a return: "If I were a rich man, I would buy the largest subprime business in the country, because it will be back."

US mortgage difficulties to continue next year

There are now forecasts that mortgage defaults and foreclosures will continue into 2008; comparisons are being made with similar drops in the early 1980s and 1990s. Peter Schiff reminds us that the biggest losers will be the lenders, but to the individual mortgageholder that won't seem comforting.

US house price bubble has been deflating for some time

Tim Iacono in Seeking Alpha (July 5) reexamines the housing market to check underlying trends at different price levels, and finds certain sectors have been dropping for some time. As in the UK, the overall average has been skewed by way the high end has held up; a more detailed examination suggests the decline for ordinary houseowners is well under way.

UK housing market also a bubble

The conventional view is that house prices are still rising in the UK. Merryn Somerset Webb, editor of Moneyweek, begs to differ (25 June) and the index to which she refers is here; Michael Hampton (Financial Sense, July 5) is also pessimistic.

For those who want to know what prices houses have actually fetched, see Nethouseprices.com, which gives much other useful information.

Marc Faber on the world bubble and his own investments

I have already referred today to Faber's interview on Minesite.com and would like to pull out one or two strands:

Faber thinks "...all real estate markets around the world are in cuckoo land and that they will all correct at some stage meaningfully even if you print money".

Asked whether he has real estate himself, he says, "I own properties in Asia, in New Zealand and in Vietnam in particular and in Thailand, and Indonesia and some in Switzerland; but ... I never borrow money to buy my properties, I pay cash ... I also own gold, and I also own some shares of course, I’m just diversified; but in general, I am very liquid at the present time... I’m holding a lot of cash at all times."

Re precious metals and inflation: "I tell you, the US has no other option but to print money. And they’ll go down like the Roman Empire in a huge hyperinflation. " He is bullish on silver and gold (especially gold), though he notes the danger that in a crisis, the government may simply expropriate investors' holdings of precious metals, as has happened in the US before.

Faber also notes that the expansion in the money supply in the West is not matched by increases in GDP, which is why we have speculative bubbles and a stalled standard of living: "...in the 50s and 60s and 70s if you increased your debt in the United States by $1 you got essentially also a dollar's worth of GDP growth. Now in the last 5 years, total credit market debt in the US has grown by $13 trillion but GDP by just $2.3 trillion." By contrast, in the East, living standards have risen: "I moved to Hong Kong in 1973. When I came, Taiwan, South Korea were very, very poor countries, as well as Singapore was like a dump at that time. Today, Singapore is the richest country in the world and, you see that the standards of living of people, has over the last 30 years, improved very dramatically in these countries. Whereas in Switzerland I go there, back, a few times a year I don’t see any meaningful improvements in the standard of living."

I think I have to speak personally now. What worries me, since I'm not rich and live in a large ex-industrial city, is not how to profit from the crash, as Peter Schiff advises, but what my life is going to be like when my neighbours and their children are strapped for cash, unemployed (or in Mcjobs) and increasingly resentful. Shouldn't we get our noses out of the financial press and start to become concerned about the social cost of the folly and cynicism of our banks and governments?

How long can Japan power world stockmarkets?

An interesting audio file of Gary Dorsch (Global Money Trends, Sir Chartsalot) being interviewed by Jim Puplava (Financial Sense) on 16 June.

He notes UK Chancellor of the Exchequer (i.e. finance minister) Gordon Brown's denial that increases in the money supply are closely correlated with inflation, and says that this is why governments around the world don't raise interest rates fast enough and high enough. (Now that Gordon Brown is Prime Minister, I don't expect a sudden change of heart.)

Dorsch also notes that foreigners are becoming reluctant to keep pumping cash into US Treasury bonds, and bond yields are rising. He regards the yield on the 10-year bond as critical for housing and stockmarket valuations.

He also notes that Japan is resisting rises on its own 10-year bond yield, for fear of a strengthening yen and weakening trade balance; but the rate (c. 2%) is still so incredibly low that traders are borrowing vast sums (the Japanese have $7.5 trillion in bonds, I think Dorsch stated) to invest in global equities. So until there is a significant hike, the "carry trade" will continue to help inflate stocks. He wonders whether at some point, "bond vigilantes" will have enough strength to force an interest rate rise.

Meanwhile, Dorsch notes growing interest in commodities. He likes producing countries such as Canada, Australia and Brazil, and thinks that the ever-growing demand for base metals and energy (especially oil) from China and India will bear them up on the tide.

Housing corrections and stock corrections related

Tim Wood, in Financial Sense (13 July), tracks housing cycles and the Dow, and predicts a drop in the Dow sometime, to follow the drop that has already occurred in housing. He also sees a series of 4-year cycles; Contrary Investor connects the Dow and Presidential terms, in an article earlier this month.

More on housing loan losses

Stephanie Pomboy's MacroMavens site gave this worrying picture of banks' exposure to real estate risk, on 7 June 2005 - (I'd be grateful for an update for 2007). The Mogambo Guru recently (12 July) quoted her firm as saying (in Barron's) that $693 billion of mortgages are now in the red, with a possible $210 billion in outright losses.

Marc Faber interview on Commodity Watch Radio

Read Marc Faber's 3 April overview of the economy, commodities and mining on Commodity Watch Radio at Minesite.com - Part 1 here, Part 2 here. This site has a number of enticing webcasts - Minesite is one to bookmark, especially for commodity investors.

Inflation, housing losses and a stockmarket bubble.

Richard Daughty aka The Mogambo Guru lays about him on 12 July. The housing bubble continues to deflate and inflation is up.

Apparently M3 (no longer reported as such by the Fed) has risen from 8% to 13.7% since figures ceased to be released officially. Looking across the water at the UK, our M4 (bank private lending) has averaged over 13.5% over the four quarters ending 31 March, so it seems we're in the same boat.

A disturbing element in Daughty's report is the notion (relayed from Gary Dorsch at Global Money Trends) that the strategy of US Treasury chief Henry Paulson is to engineer a stockmarket bubble to offset the losses in the housing market. This, as cinemagoers used to say in the days of continuous showing, is where we came in.

Puru Saxena: natural resources at bargain prices

Like Jim Puplava, Puru Saxena (yesterday) sees a bull market in commodities, not merely on account of monetary inflation but also in view of increasing demand.

Puplava on the commodities bull market

Jim Puplava's Financial Sense Newshour, July 7: having discussed what he sees as a long bull market in energy, Puplava turns to other commodities such as gold and silver: "the best protection in inflation has always been gold and silver, which represents real money". He sees a new "leg up" in the market within 3 to 6 months, because of the continuing inflationary expansion of money and credit. Another factor will be A&M - "junior producers" being acquired or merged to achieve economies of scale.

So as a hedge against inflation for the small investor, he recommends regular savings into a mutual fund in energy and precious metals, or even commodity ETFs (exchange traded funds) in energy and food.

Puplava on value investing

Jim Puplava's Financial Sense Newshour, July 7: to get rich slowly but surely, invest in companies that pay high dividends.

Puplava quotes research showing that over 100 years, the stockmarket has grown by 5.4% per annum, but reinvesting the dividends raises the return to 10.1% p.a. Over a long period, this margin compounds up impressively.

Features he suggests you look for:

• a low P/E ratio (i.e. a high dividend proportionate to share price)
• essential industries - companies that make things people need constantly or frequently (e.g. energy, consumer staples)
• companies that have a record of increasing dividends over the years
• larger, more mature companies - ones that have gotten past the stage of having to plough back most of their profits into R&D
• strong cash flow and earnings growth
• good management and solid corporate governance

In response to a listener's question, Puplava opines that the utility sector is currently "grossly overvalued", but says there may be reasonably-priced shares available in oil and consumer product companies.

Puplava on the energy market

Financial Sense Newshour, July 7: Jim Puplava sees a long bull market in energy.

This is because there is a long-term upward trend in demand. In the West, we use more devices in the home - and in the US, new homes are actually getting bigger, requiring more energy for space heating; and in the developing world, people are keen to join the consumer lifestyle - "Next year, emerging market energy demand will surpass industrialized countries' energy demand for the first time in history". Meanwhile, extraction costs are rising.

Puplava sees 3 themes in relation to the energy market:

• efficiency
• new types of transportation (e.g. hybrids), or more use of old types (e.g. railways, barges)
• substitute fuels (e.g. ethanol) / alternative energy resources (especially nuclear, solar and wind)

Puplava on subprime lending

For the time-challenged, I propose to highlight sections of Jim Puplava's Newshour. "Financial Sense" is what it says on the tin and I plan to make this a regular read/listen. Working off the transcript for July 7 (and that's another very laudable feature of his service), here is my interpretation of some points he makes about the subprime crisis:

The real sting of subprime defaults is in how they may affect the credit ratings of CDOs (Collateralised Debt Obligations, i.e. mortgages grouped together and sold on as interest-yielding investments). Some major institutional investors, including pension funds, have bought CDOs, but are required NOT to hold any bonds below "investment grade". So if these CDOs drop below a "BBB" rating, the fund managers will be forced to sell, and if there is a wholesale selloff there will be a sharp drop in the price.

Also, the hedge funds that invest in CDOs may have borrowed 10-20 times the value of their capital, to multiply their investments. The margin of safety is thin and a relatively small loss could trigger a cash call. So although Federal Reserve officials are correct in saying that subprime debt is only a small proportion of the lending market, this borrowing-to-invest vastly magnifies the problems.

Another complication is that credit ratings don't mean the same thing for all types of bond. Over the last decade or two, "BBB" rated corporate bonds have had a default rate of 2.2%, but BBB-rated CDOs have a 24% default rate. Do all investment managers fully realise this?

There is over $200 billion in subprime bonds that need to be re-rated, but rating firms are putting off the evil day. One reason for the delay is that the ratings people have a conflict of interest. It seems that many were involved in designing the CDOs in the first place, so if a re-rating happens soon, awkward questions will be asked and reputations shredded. There might even be litigation for damages. Meanwhile, Puplava speculates, the government itself might wish to encourage a more gradual unfolding of the bad news, to prevent the avalanche.

More on real inflation figures via iTulip

Further to my post of 9 July re "real" inflation, I have received the following comment from the originator of the charts - thanks.

I am the author of the charts referenced above. For the latest, see here:

http://homepage.mac.com/ttsmyf/RD_RJShomes_PSav.html
http://homepage.mac.com/ttsmyf/recDJIAtoRD.html
http://homepage.mac.com/ttsmyf/newestHousData.gif

FYI, thru today 7/12 for the Real Dow, and thru 2007 Q1 (= mid-Feb 2007) for Real Homes: Real Dow is 2.24x the +1.64 %/yr curve, which is a 55% drop thereto, and Real Homes national (green points) is 1.78x the ca. 54 level, which is a 44% drop thereto.

Listen to Financial Sense!

Click here for the transcript of July 7's edition of Jim Puplava's Financial Sense Newshour. This is a wide-ranging overview, from subprime loans to commodity investing and listeners' queries.

Soothing noises from the US Treasury re subprime losses

Treasury officials are quoted in Bloomberg, saying that subprime losses don't represent a systemic threat. Another official, Frederic Mishkin, said something similar at the Levy Economics Institute symposium this month (see my blog of 5 July).

Cash still king?

British investment portfolio manager Tim Price gives his reasons for favouring cash in the present economic circumstances. The post is a few weeks old, but echoes similar intimations from Marc Faber. Price has also reviewed Michael Panzner favourably.

Peak oil, commodity prices, globalisation, back to the land

An interesting article from Tom Stevenson in Britain's Daily Telegraph, on oil. He reaches two conclusions:

1. it's good news for the commodity investor
2. when supply hits its limit, demand will have to change, and so will our lives

The second is far more interesting. I think we will eventually start listening to the dreamers who are even now formulating new currency systems for localised commerce. And we'll need to unwind our dependence on the car. Think of the implications.

"Real" mortgage rates - a real estate expert writes

A real estate expert, Jonathan J Miller, comments and expands on Barron's recent article on "real" mortgage interest rates, and the state of the housing market generally. I have added Matrix to the bears' link list.

Housing to drag the Dow down?

iTulip is pessimistic about the effect of a housing downturn on the US stockmarket, and skeptical about reported GDP.

Presidency a cyclical influence on the market?

Contrary Investor's July report examines stockmarket cycles in relation to Presidential terms, and draws some tentative but suspicious conclusions.

Marc Faber: "Buy early, exit early"

Marc Faber gave us his approach in the Financial Express on Sunday, and his currently bearish outlook on most classes of asset. Like Sir John Templeton, he believes in buying when the pessimism is at its height. He's also quite dismissive of fund managers' performance.

Peter Schiff: will Japan pull the plug on America?

Peter Schiff, in The Market Oracle yesterday, reports that Japanese monetary inflation is about to show up in their consumer prices. They may be able to cover it by fudging the inflation index (some of us have seen that done elsewhere), but it can't fool everyone forever.

For a long time, Japan has increased its money supply and exported the excess cash by purchasing US Treasury bonds. This keeps the yen steady against the weak dollar, protecting Japan's exports; and it also keeps US interest rates low, so reducing the pressure to raise rates in Japan.

Schiff felicitously terms this a "vendor financing scheme", but regards America's economic collapse as "inevitable". He thinks hyperinflation is too high a price for Japan to pay, and if she retreats from the brink and alters her monetary policy, then the result will be inflation in the US, forcing higher interest rates, and collapsing stock and real property values.

This is what Schiff has predicted in his book, "Crash Proof" (see my review here) and it's interesting to note that the author has been appearing more frequently in the news lately. Either he thinks the turning point is close, or he's marketing the book more actively.

Schiff also comments on the fear of deflation, saying "falling consumer prices are one of the natural rewards that people enjoy in market economies", a point made in Richard Daughty's masterly performance on You Tube. It's so funny and succinct that I re-watch this myself from time to time - have another look:



UPDATE

For a counter-view (in the sense that he doesn't expect the crisis for some years yet), see Puru Saxena as I reported on July 28 here.

Americans should invest abroad - Wasik

Writing in Bloomberg yesterday, John Wasik considers how Americans should invest, since homes, equities and bonds all seem poor value. He recommends high-yielding foreign (i.e. non-US) equities, something Peter Schiff (Crash Proof) has been tipping for quite a while. This, he thinks, will provide yield but also hedge against further falls in the dollar's exchange rate.

Energy crunch = higher food costs

Continuing the theme of energy demands, the Contrarian Investors' Journal comments that the search for alternatives to oil is causing inflation in food prices.

Energy crunch?

Frederick Sheehan's article Reaping the Whirlwind, originally posted in Whiskey & Gunpowder, is reproduced today in Prudent Bear. The prose is rather poetic, but the issue is how an overheated world economy is straining the world's capacity to grow energy supplies to cope. Worse still, new housing designs in the US and upgraded housing in the developing world, are building-in permanent excessive energy demand.

Safe Haven suggests Dow 9,000 "in the intermediate term"

Chartist Robert McHugh at Safe Haven reads the runes and predicts a significant correction for the Dow - in real terms (i.e. as measured against gold), if not nominal terms.

How far to fall? iTulip on the Dow and house prices

iTulip shows charts that follow the Dow and house prices, comparing them with inflation over a long period. The implication of the way this information is presented, is that stocks are about 100% over trend, or to put it another way, have a 50% fall to get to the trend line, and house prices would have maybe a third to lose.

I would guess that in terms of crystallising loss, this is more significant for equities than for real property, because you have to live somewhere.

News hub for sub-prime mortgage issue

A contributor has kindly alerted me to a blog that explains the issues and collates news items - please click here. Sub-Prime Mess is now also on the link list (see sidebar).

Subprime mortgages: bad news and more to come

Following the collapse of Braddock Financial's $300 million Galena Street, Reuters (6 July) looks ahead to what other hedge funds will have to report.

The Mogambo Guru includes subprime loans in his latest Daily Reckoning rave. I do hope someone posts his Agora Financial conference speech onto YouTube.

Marc Faber bullish on Indian real estate

See here for Moneycontrol.com's interview with Marc Faber, where he expresses enthusiasm for Indian realty:

...I think that is a no-brainer in the long run. It is a problem for people who will have very high borrowings, against their realty because of interest rates. Realty has always been a cyclical industry, where prices move up or down. But by and large if I look at the world, the reason so many families are rich, that came out of realty, is that the money was tied up in realty. They did not do anything more stupid with their money like buying Internet stocks in 2000 and then losing 90% of their money as prices went down.

So, my advice essentially for people, if you are not an expert in financial matters, to own realty - a safer avenue to wealth.

Faber also predicts a near-future stockmarket correction in the US of more than 10%, and in the longer term:

I expect over the next 20 years interest rates in the US will go much higher than it is perceived by the market place as I think inflation in the US will accelerate on the upside partly because of the rise in the prices of commodity, energy and food. This is also partly because of the weakness in the dollar that will eventually lift import prices.

Calls for a fully-funded Social Security pension

Free Market News Network (July 2) interviewed Peter Schiff, who said that the current rob-Peter-to-pay-Paul pension system will unravel in a few years, because of demographics. Newt Gingrich (former Speaker of the House) thinks a funded pension system should be introduced, but control of the funds should be out of the hands of the government.

This is very similar to proposals put forward in the UK by the Pensions Reform Group, chaired by former minister for welfare reform, Frank Field MP. The working name for it is a "Universal Protected Pension". The proposals betray the same worry as Gingrich implies, which is that the government may find a way to steal all or part of the fund.

Houses and mortgages - reality worse than the news?

Rachel Beck of AP has an article in The Arizona Republic (July 3), showing that dodgy housing data may be understating the scale of the problems.

Living off our inheritance: global wealth distribution, GDP and debt

The World Institute for Development Economics Research of the United Nations University (UNU-WIDER) launched a report last December, about household net worth around the world. Here's a nugget or two from their press release:

“The study finds wealth to be more unequally distributed than income across countries. High income countries tend to have a bigger share of world wealth than of world GDP.” (p. 3)

This suggests to me that the wealthy countries are to some extent living on their capital.

‘China … fails to feature strongly among the super-rich because average wealth is modest and wealth is evenly spread by international standards. However, China is already likely to have more wealthy residents than our data reveal for the year 2000, and membership of the super-rich seems set to rise fast in the next decade.’ (p.4)

Surprisingly, household debt is relatively unimportant in poor countries. As the authors of the study point out: ‘While many poor people in poor countries are in debt, their debts are relatively small in total. This is mainly due to the absence of financial institutions that allow households to incur large mortgage and consumer debts, as is increasingly the situation in rich countries….many people in high-income countries have negative net worth and—somewhat paradoxically—are among the poorest people in the world in terms of household wealth.’ (p. 5 - italics are mine.)

Figure 7, “Asset Composition in Selected Countries”, shows the proportion of real property, financial assets and debt in 7 countries, including the US, Canada and Japan. Looking at the ratio of debt to financial assets, China is clearly the least debt-burdened.

When a spendthrift heir meets a poor but hard-working and hard-saving entrepreneur, the result seems predictable. Look at page 16 of Warren Buffett's 28 Feb 2007 letter to shareholders, which I quoted at greater length on July 5:

"The world is ... willing to accept our bonds, real estate, stocks and businesses. And we have a vast store of these to hand over.... [but] foreigners now earn more on their U.S. investments than we do on our investments abroad. In effect, we’ve used up our bank account and turned to our credit card."

The world is flat - or is it? Is Leamer right about Friedman?

Thomas Friedman's book, "The World Is Flat" is a best-seller - Wikipedia summary here. Friedman's related website is here - I think the photograph of the author is interesting, for those who like to read faces.

Last year, Edward Leamer reviewed Friedman somewhat snippily here. Gosh, I wish people could be more succinct. As Byron wrote of Coleridge, "I wish he would explain his explanation". Still, I guess Leamer has to fly the flag for critical scholarship.

The issue is important: does globalization threaten America's standard of living? Free traders say no. But have a look at Figure 6 on page 33 of Leamer, showing global income distribution in 1980, when US per capita GDP was 4 times the world average. That's quite some inequality, and if they were two very different levels of water in the same canal, opening the lock between them would see wealth gush from A to B.

So as barriers to trade are coming down, why hasn't this happened? Leamer says (p.34), "Much of the difference in GDP per capita among countries comes from the greater amounts of physical and human capital in the West, which advantages aren’t going to go away any time soon."

I'm not so sanguine. As regards human capital, I think the East is very keen indeed to increase its investment in education and training, and isn't hampered by notions of equality of outcome for its students. As to industrial capital, we are watching a vast sucking-in of resources, right down to our iron manhole covers, by China and other emerging economies; but also (particularly in China) we see a rapid and determined acquisition of slowly-accrued Western intellectual capital.

I think the catch-up process would be even faster in China if their industries observed patent and copyright more scrupulously, so they weren't almost wiping out each other's profit margins in their domestic market; and financial capital will accumulate far more rapidly when Chinese manufacturers get to keep more of the foreign buyer's price, instead of losing most of the profit to shippers, distributors, marketers and advertisers. If I were Chinese, I'd be looking at those areas for the training of my bright young people; and I bet they are.

Figure 7 on page 35 compares global income distribution in 1980 and 2000. The rich have done fine, the middle earners have made almost no progress, the poor are gradually rising. But when you think about it, maybe the middle is progressing: Western industrial workers are losing their jobs and looking for work in less well-paid service industries, while new industrial jobs are being created abroad. James Kynge ("China Shakes The World") says he sees heavy industry taking over on the Chinese coast, and labour-intensive light industry being forced inland. The move from low-skilled to higher-skilled labour in China is certainly a progression, matched by downward movement in the West. I wonder what the higher end of the graph will look like in another 20 years, when the Chinese have their own armies of industrial tycoons, company VPs, economics professors, investment analysts and marketing experts? I bet they're quite content to watch their coolie-work go to even poorer countries, as long as it doesn't happen too soon in the game.

Leamer admits (p.46): "The real bottom line: we do not know the breadth and intensity of global contestability of US jobs, and until we do, we will not have a real handle on the impact of global competition on the US workforce."

Why is he relaxed? See page 48:

"Finally, I want to comment on what I think is the big issue. It isn’t globalization or a flat world; it’s technology and the post- industrial labor markets.

The US is in the midst of a radical transformation from industrial to post-industrial society. Some of this transition is associated with the movement of mundane manufacturing jobs to low-wage foreign locations, but much of it comes from the dramatic changes in technology in the intellectual services sectors. The policy response to the globalization force is pretty straightforward: we need to make the educational and infrastructure investments that are needed to keep the high-paying non-contestable creative jobs here at home and let the rest of the world knock themselves silly competing for the footloose mundane contestable jobs."

Well, I don't think the rest of the world is quite as silly as that. I don't think Western education systems are geared to excellence, as once they were; so for that reason, as well as IPR enforcement issues, I don't think we can bank on using our intellectual property to sustain our global income differential. I don't think multinational businesses have, or feel they can afford, nationalistic sentiment. And whenever I read statements that start "we need to do x", I get the feeling that x isn't going to happen. Individuals will still make their stellar way, but I can't envision the West as a whole reclining in comfort in a "post-industrial" society.

But maybe I'm wrong.

Soros increases his mining stocks

Coat-tail Investor reveals Soros' largest holding by far is Companhia Vale Do Rio Doce, the world's second-largest mining corporation. Soros has increased his holding by around 10% as of end March. He's obviously sold on the commodities/natural resources/industrial metals theme.

A useful feature of the Coat-tail site is that you can re-order the information by clicking on each column heading, which makes searches much easier.

Portfolios of leading investment managers

Here's a site that claims to reveal the investment portfolios of top managers such as Warren Buffett and George Soros. I don't suppose it will be able to say when they got into a stock, and at what price, but it should be instructive.

Subprime debt as a form of gambling

Those who are concerned about Bear Stearns and the subprime mortgage fiasco should read Paul Tastain's article in today's Daily Reckoning. He explains in detail how junk lending has gone from risky investment, to default insurance and ultimately to a kind of gambling. Some of the worst of this product has been bought by institutional investors, such as pension funds who have been almost forced to buy it by legislative pressure to increase bond holdings. He guesstimates potential losses in the region of $72 billion, or 20 times what it cost to bail out LTCM

These are certainly large figures, but maybe we should look at them in context. Interpreting the Russell 3000 Index data on this site, total US equities were worth around $15 trillion in 2005, and obviously rather more now. The 2007 estimated Federal Budget outlay is $2.655 trillion. That would make the putative $72 billion junk mortgage loss only about 0.5% of US investments overall, or some 2.6% of US government expenditure.

But the article is a wonderfully clear example of how systemic risk is created and expanded.

Some highlights from the Levy Economics Institute

A few nuggets from the July 2007 Levy Economics Institute conference:

Dimitri Papadimitriou foresees an improving current account deficit over the next three years. Private sector debt should level off as a proportion of GDP. The Congressional Budget Office's forecast and targets for 2010 assume continuing home borrowing, but if this doesn't happen, the model suggests that budget deficit needs to increase to 4.6% of GDP. The alternative is a depreciation of the dollar, which is unlikely because (a) this would increase inflation and (b) China does not wish the renminbi to rise significantly against the dollar. A propos the last, Robert Barbera explained that a renminbi appreciation would raise the price of China's farm products and hit the living standard of its large rural population.

Robert Parenteau looked at US private borrowing: "the prospect of a hard landing should be taken seriously".

Wolfgang Muenchau of the Financial Times thinks that despite having stronger fundamentals than America, Europe is likely to be affected by a US downturn, because European stocks, property prices and interest rates tend to follow America's lead, and a strengthening of the Euro against the dollar would hit European exports and economic growth.

Torsten Slok considered longer-term inflationary pressures in the US: demands for pay raises, an increasing proportion of retirees overstraining the budget, and the possibility of an overheating Chinese economy that would up US import prices.

James Paulsen thought that the US could regain some of its consumer market share through "a long-term sustained contraction of its trade deficit to revive domestic manufacturing".

Frederic Mishkin of the Federal Reserve was relatively relaxed about subprime borrowing, saying that such loans represented less than 10% of all mortgages.

Buffett on trade imbalances

Warren Buffett's 28 February 2007 letter to shareholders is available online, and makes educational and entertaining reading. Here's a pithy extract:

As our U.S. trade problems worsen, the probability that the dollar will weaken over time continues to be high. I fervently believe in real trade – the more the better for both us and the world. We had about $1.44 trillion of this honest-to-God trade in 2006. But the U.S. also had $.76 trillion of pseudo-trade last year – imports for which we exchanged no goods or services. (Ponder, for a moment, how commentators would describe the situation if our imports were $.76 trillion – a full 6% of GDP – and we had no exports.) Making these purchases that weren’t reciprocated by sales, the U.S. necessarily transferred ownership of its assets or IOUs to the rest of the world. Like a very wealthy but self-indulgent family, we peeled off a bit of what we owned in order to consume more than we produced.

The U.S. can do a lot of this because we are an extraordinarily rich country that has behaved responsibly in the past. The world is therefore willing to accept our bonds, real estate, stocks and businesses. And we have a vast store of these to hand over.

These transfers will have consequences, however. Already the prediction I made last year about one fall-out from our spending binge has come true: The “investment income” account of our country – positive in every previous year since 1915 – turned negative in 2006. Foreigners now earn more on their U.S. investments than we do on our investments abroad. In effect, we’ve used up our bank account and turned to our credit card. And, like everyone who gets in hock, the U.S. will now experience “reverse compounding” as we pay ever-increasing amounts of interest on interest.

I want to emphasize that even though our course is unwise, Americans will live better ten or twenty years from now than they do today. Per-capita wealth will increase. But our citizens will also be forced every year to ship a significant portion of their current production abroad merely to service the cost of our huge debtor position. It won’t be pleasant to work part of each day to pay for the over-consumption of your ancestors. I believe that at some point in the future U.S. workers and voters will find this annual “tribute” so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict – but to expect a “soft landing” seems like wishful thinking.

It's reassuring that Buffett thinks per-capita wealth will increase; this is an antidote to the most extreme doomsters. But it begs the question of how equitably that wealth will be distributed. The transfer abroad of industrial jobs leaves most of their former holders in less well-paid employment, while boosting the profits of large multinational companies (such as Wal-Mart, in which Berkshire Hathaway has close to a billion-dollar stake). From James Kynge's China book, it seems that the gap between America's rich and poor is widening, and the middle class is shrinking. Save and invest while you can.

Buffett is also enlightening on the future of newspapers in the electronic age, and the occasional bargains to be had in insurance. His firm has made money out of carefully-considered reinsurance (including for Lloyds of London) and derivatives. Berkshire Hathaway has gradually moved from being a "growth" to a "value" business, delivering returns increasingly from income earned, and insurance business helps. BH has made a profit from "super-cat" insurance in the past year, but Buffett warns that Hurricane Katrina wasn't the last nor the worst possible.

Note also the warning in the extract about the dollar. Recent falls aren't the end of the necessary decline - see to the Levy report referred to in my previous post.

Global imbalances: new report

Please click here for the July report from the Levy Economics Institute: "Global imbalances: prospects for the U.S. and world economies".

Railroads: further details

Chris Mayer writes about railroads in today's Daily Reckoning Australia. After describing Chinese technical feats, he looks at factors that make railways more attractive in today's America:

- Container transportation is booming as America imports more of its non-perishable goods. But fuel costs are rising. The energy-efficiency of rail is an advantage over trucking.

- The US population continues to move to the cities, where land is at a premium. Rail is more space-efficient, and less polluting than cars or planes.

So Buffett is doing his customary thing, of backing dull, dependable, comprehensible business that's going with the flow.

Looking at wider issues, maybe a highly concentrated population implies not only highly-capitalised amenities, but centralised power. How will America change as urbanisation continues? Will the internalised society (life governed by shared expectations of decent behaviour, liberty, egalitariansm) become a society of rule imposed from outside and above?

As it happens, I am reading Bill Bryson's childhood memoir of Des Moines, Iowa and the Fifties ("The life and times of the Thunderbolt Kid"), and he remembers when America had millions of small, family-owned farms and the Midwest was dotted with thriving little towns. When the farm went, what went with it?

And coming back to the resource-efficiency/sustainability arguments, I have an idea that although cities seem to be more efficient (because people are closer to each other), they are highly entropic - it takes a lot of work to stop them falling apart in all sorts of ways. Maybe the more distant future is back out on the prairies, with a return to localised production and self-government.

A note of caution about the Gold Standard, and the Euro

Until I looked it up (isn't the internet wonderful?) I had thought that the "Geddes Axe" (which slashed UK public expenditure) was a response to the Depression. Far from it: some would say it was a major cause. It turns out that after the First World War, our politicians wanted Britain to be great again, and thought that meant getting the pound back up to its former exchange rate against the dollar - just as I dream about getting into my old teen jeans.

They managed to do it for a while, but the result was a deflation that failed to take into account Britain's postwar economic weakness, and the 1925 restoration of the gold standard at this fatally high level prolonged the suffering. Then the zip bust.

More recently, some felt that lacing the pound into the Euro would stiffen our backs. Or perhaps this idea owed more to fuzzy notions of European brotherhood, modernity etc - we in Britain have had ten years of being led by a fuzzy thinker.

But not all agreed that the time was right - see the 2002 Cairncross lecture by Ed Balls. This lecture, by the new Prime Minister's former economic adviser (see Wikipedia bio), sets the historical context for the "five tests" that he formulated with Gordon Brown in a New York taxi in 1997. The tests were designed to determine the timing of the UK's entry into the Euro - for details, see this Scotsman article of 2003, which also reviews progress. Perhaps the timing will never be right.

Some hope that's the case -because it's not just about economics. Can Europe ever be a country? What will happen to our mode of government, civil liberties and economic prosperity in this herd-rush towards an "ever-closer union" commanded by a remote, opaque elite?

Is currency stability generally desirable? Sure; but another return to fixed exchange rates would certainly need extremely careful management, especially in fundamentally unstable conditions. I don't think Western trade deficits are purely due to monetary inflation; China's rapid rise from poverty seems just as challenging to our budgets as the Great War that drove us off the gold standard.

The Mogambo Guru on the lost days of rising real wages

Richard Daughty's latest piece, posted on GoldSeek, does the usual and then harks back to a time when employers were trying to cut wages because the workers were getting richer, thanks to a solid currency and steady economic improvement.

Faber in person, and "always long on gold"

While we're doing the visuals, let's have a look at Marc Faber. I find you can learn so much about people from their face, voice and physical posture. Faber comes across as frank, clear, careful to say it right, thought-out.

This interview is several months old, but has many nuggets of enduring value, such as a possible 30-40% drop in emerging markets, political prospects for Thailand, Japan as a buying opportunity, and gold as a store of value against the relentless decay of paper currency.

Note how he says at the end that Americans should not hold gold in America, for fear of expropriation in a crisis. Warnings like that made in his gentle and cautious way are all the more stark.

Part 1:



Part 2:

Inflation? We should be enjoying gentle, long-term deflation!

Richard Daughty, aka The Mogambo Guru, is on YouTube! In print, his rants are so funny that you can forget he's entirely serious. Here, he goes through the theory of money and the scam that is inflation, in two-and-a-half minutes. A gem, as they say.

Inflation: the evidence

If you want to see what monetarists would assert is the fountain of inflation in the UK, here are the M4 money supply figures from the Bank of England, going back to 1963.

The average rise over the whole series is 13.485% per annum; over the last, "prudent" 10 years, 9.99% p.a.

To put it another way, if £1 could have been invested in 1963 at an interest rate that kept pace with this monetary expansion, it would now be worth something like £261. And that's assuming you would have been allowed this interest tax-free, so as to preserve the value of your money.

Contrast that result with the inflation statistics as given by this paper in the House of Commons Library. The figures only go up to 1998, but let's assume purchase prices kept to their approximate target of 2.5% p.a. after that. According to this research, a "basket" of goods and services worth £1 in 1963 would now cost about £15.

Where has the rest of the inflation come out? Asset prices, presumably, or bank profits. Or have the monetarists got it wrong?

One thing's for sure: even after adding net interest at available rates, cash savers have seen an enormous, long-term dilution of their share of the country's circulating money. They would, I estimate, need to receive about 6.7% per annum ABOVE purchase price inflation, to match the money supply increases.

If I've got it wrong, do please show me where the error has occurred.

The Daily Reckoning's Blog

The Daily Reckoning blog started in April 2006 and also features some free reports. You may wish to link / contribute to it.

What's wrong with money?

Many a truth is spoken in jest, and Douglas Adams' "The Hitchhiker's Guide To The Galaxy" is full of wry truths. Here's one about money on Planet Earth:

Most of the people living on it were unhappy for pretty much of the time. Many solutions were suggested for this problem, but most of these were largely concerned with the movements of small, green pieces of paper, which is odd, because on the whole, it wasn't the small, green pieces of paper which were unhappy.

It's odd how money seems more important than the here-and-now. Some would say that money changes real life for the worse, because it is a distorted representation of reality.

One solution is to try to amend the money system. This site reproduces the text of Richard Douthwaite's "The Ecology Of Money", a piece on money and community currency systems.

Another is to try to live without money, or nearly so, and instead have a more direct relationship with the land - for example, the Tinker's Bubble community in Somerset. I don't know whether the whole world can go that way - not everyone is so skilful, or can get hold of such lovely land and resources in such a relatively peaceful, prosperous and tolerant country; but to quote the poet Elizabeth Jennings, "sickness for Eden was so strong".

Meanwhile, the rest of us have to use some of our precious time, trying to prevent the value of our savings being stolen by inflation, and avoiding the worst consequences of an ill-managed economic system that, if it breaks down, could lead to a long period of hardship.

The Australian housing market suffers, too

It's not just the US and UK that suffer from home lending problems. The Contrarian Investors' Journal commented yesterday on housing-related debt and reduced property valuations in Australia.

Subprime lending in the US housing market rocking the boat

The Bloomberg financial site is following the subprime mortgage story, and quotes Peter Schiff (see my review of his book) as predicting that the majority of such loans will default.

In the US as in the UK, inflation has made house prices rise fast, and in turn this has encouraged lenders to offer mortgages almost recklessly: high loan to valuation (sometimes even more than 100%), borrowers with a less than perfect track record of honouring their commitments.

Also, and unlike in the UK, the US mortgage has traditionally been a long-term, fixed rate deal, but more recently, many homeowners have taken out loans with a short-term, very low initial interest rate, and now they are coming out of the initial period into higher, variable rates. This would be a challenge anyway, but the variable rates are rising as the government seeks to rein in inflation.

You would expect that the lenders have most to worry about, but there has been a trend towards putting blocks of these debts together and selling them on to third parties as income-yielding investments. Since this gets risky debt off the lenders' hands, the lenders don't mind doing more of the same, so there is a temptation to become careless about quality.

But that risk has been transferred to the investment market, so a wave of defaults will hit returns on investments. And the investor isn't always quite aware of the degree of risk involved. The worst-risk packages are known as "equity tranches" and some have been sold to pension funds - see Michael Panzner's submission to Seeking Alpha. Some would see this hawking of bad risk as looking for suckers, and even with knowledge of his fiduciary obligation, the buyer may sometimes be a bit more gullible if it's not his own money he's investing.

Panzner: data opacity - fear of the financial truth?

The Federal Reserve stopped publishing its M3 data (the widest definition of the money supply) from 23 March 2006, and this occasioned much suspicious comment.

Now, in two posts on his Financial Armageddon website (27 and 29 June), Michael Panzner writes about the lack of transparency in the Bear Stearns sub-prime mortgage debacle, and the failure of credit rating agencies to downgrade Bear Stearns bonds.

It always looks bad if the doctor won't tell you how you're doing.

A weakening dollar means lower US living standards

Addison Wiggin in yesterday's The Daily Reckoning Australia spells out how the dollar, US debt and declining American living standards are related. Some will contest this proposition fiercely - have a look at the recent globalization thread on Cafe Hayek, for example.

For those who read the bruising commentaries (this seems to be typical of blog-related correspondence), I did look at the articles to which LowCountryJoe referred me, but the first only makes clear what a fiat currency is, and the second theorized that all currencies must originally have had some intrinsic value. Neither of these articles disproves the bears' contention that there is a horrible temptation to inflate fiat currencies for temporary advantage, and that the end result is a flight from those currencies. We shall have to see.

It's an ill wind...

A funny piece by Tim Hanson in The Motley Fool for June 26. He makes the point that travelling to a place may not change the facts, but can change your perspective, and he is bullish on some sectors of China stocks.

As you might expect, given that the outgoing tide of wealth from the West is rising in the East and floating Chinese boats. They will bob up and down, and some may tip over, but that seems to be the trend.

Richard Duncan's worry is that the ever-inflating dollar is causing the markets to operate inefficiently, so that China's rise may be preceded by a crisis that creates a long and deep global slump. I really must post a summary of his book soon.

Richard Daughty becomes spotty

Another entertaining rant from Richard Daughty, aka The Mogambo Guru. He passes on to us a sighting of Hindenburg Omens (see Investopedia definition here), raves about credit creation, and finally breaks out in sunspots...

Apparently several different sunspot cycles can be correlated with variations in marine life productivity, and the biggest threat to the environment since 200 years ago is a predicted global cooling, starting in 2020. Read the Financial Post article here and Melanie Phillips' related eco-contrarian article here.

More on railroads, Buffett, Soros

Further to the last post, the Santa Fe railway is now owned by Burlington Northern (BNI), in which Warren Buffett's Berkshire Hathaway has recently increased its stake to over 10%; and this 2002 article in the Observer reveals that George Soros worked as a railway porter. I expect Soros has his hard-headed reasons for his own investment, but it's hard to rid yourself of the love of choo-choos.

Soros' views as summarised in the Observer article resonate today:

His basic arguments remain the same - that centralised institutions need strengthening as a political counterweight to economic globalisation; financial markets are inherently unstable; and there is an inbuilt inequity, or centre-periphery, problem.

...he is examining the minutiae of the workings of the World Trade Organisation, and statistics on capital flows to developing countries.

...there is no level playing field in the world economy. The rules of the game favour the rich, or 'centre', countries. 'Within the well-developed global markets, the centre has a considerable advantage over the periphery because the centre is in charge. And contrary to the false ideology of market fundamentalism, financial markets do not tend towards equilibrium, they need to be managed. So whoever is in charge has a distinct advantage,' he says.

He says conditions set by the IMF during financial crises tend to reinforce boom-and-bust cycles. 'They push countries into recessions by forcing them to raise interest rates and cut budgets - exactly the opposite of what the US is doing in similar circumstances,' he writes in the new book. [i.e. "On Globalization"]

He is also critical of the US obsession with 'moral hazard' - that intervening in financial crises rewards incompetent investors. Bailing-in private investors has replaced bailing-out crisis-ridden countries, he argues. Such policies are building a 'new Maginot line', fighting yesterday's war against credit crises rather than focusing on the real problem of the calamitous collapse in investment flows to developing countries.

Buffett, Soros, railways - a thought

Many years ago, I read a series of books by a financial expert calling himself "Adam Smith". In one, he spoke to an investment manager who had bought a holding in a railway, I think the Santa Fe, and asked him why so, since the company was somewhere around bankrupt. The manager replied that he was looking at the value of the tangible assets still owned by the company - land, rolling stock etc.

Railways tend to own a lot more land than the bit the rails run on. Is this a reason for Buffett and Soros to have gotten into that kind of business?

Not yet, the crash - Puru Saxena

Puru Saxena submits "The Solitary Bear" in today's Daily Reckoning Australia. He agrees with Marc Faber that there's bubbles in equities and commodities, but thinks we have some years yet before the crisis hits.

This is because he can't see central bankers having the virility to raise interest rates sufficiently to curb inflation, which is rotting savers' money (the "solitary bear" market being cash). Why the reluctance? "The central banks know full well that with debt at its current level, such drastic measures would probably cause a global depression, widespread unemployment and social unrest. So, they will try and avoid or delay this outcome as much as possible..."

We're practically forced to invest in something. The danger, particularly for small guys, is not knowing when to head for the exit, ahead of the rest of the panicky crowd. It's a tough one:

"...investors will have to become more selective when making decisions and deploying their capital. For maximum success and safety, I would urge you to invest your capital during pullbacks whilst avoiding overstretched markets. Despite all the talk of "doom and gloom", this strategy should continue to deliver reasonable returns in the period ahead."

I wonder whether the "gloom and doom" is in part an oblique reference to Marc Faber, whose website is self-deprecatingly named gloomboomdoom.com. See Faber's comments in the Market Oracle round-table discussion yesterday (previous post) - he, too, admits he can't call the turn but forecasts a continuing rise in equities (except maybe emerging markets) relative to cash - but not a rise in real terms. Faber is looking, I suspect, for quiet bargains in commodities and resources, e.g. low-priced agricultural land.

Marc Faber: bonds turning bearish, stocks to lose real value

Marc Faber and others give their investment views today on The Market Oracle. A quote from Faber:

We are now at the onset of a major bear market in bonds worldwide that should bring interest rates above the level in 1981 when US Treasuries were yielding over 15 per cent. But this process will take at least 10 years. In this environment stocks will not do well in real terms but will rise in nominal terms. How high will depend on (US Federal Reserve chairman Ben) Bernanke's money printing presses.

I think I have already suggested that, adjusted for inflation, stockmarkets have already fallen far below their 1999 positions, and this looks like confirmation that more of the same is expected.

Is gold a bargain?

In Monday's The Daily Reckoning, Richard Daughty notes that annually, the US is creating 24 times more new money than the world is producing in new gold at current prices, and he comes to the obvious conclusion: "Planetary Super Bargain".

But there are other ways to do the figures. The same edition of TDR reveals that we already have 150,000 tonnes of gold above ground, so 2,500 new-mined tonnes per year represents 1.67% p.a., compared with the 12% increase in the US M3 money supply. Okay, that looks like a mismatch of supply and potential demand, but this particular ratio is 7.2 times, rather than 24.

Another thought: gold and paper notes are not the only two things in the economy. People have other things to spend their money on, such as their rapidly-growing debts. And if we accept the worst-case future scenario, maybe tins of baked beans and boxes of ammunition will be in even greater demand.

Also, how far has the gold price already factored-in inflation? Using figures from Kitco.com's website, I've compared the average London PM fix in June 2002 with today's New York spot price. Per ounce, gold has gone from $356.53 to $642.50 in 5 years, a rise of around 80% overall. This equates to some 12.5% compound per annum - rather similar to the M3 figure previously quoted. So maybe gold is doing its traditional thing of storing value, more or less, rather than being a sort of asset Cinderella about to hit the big time.

But then again, I could be wrong.

Making money out of disaster?

The Contrarian Investors' Journal concludes its series on exploiting the possibility of a crash, by suggesting a series of short-term bets on the drop. It's a gamble, of course, but appeals to the Black Swan types who look for an "asymmetric outcome" - a disproportionately large payoff if the unlikely event happens. In other words, if the event has 100-1 odds against occurring, but the bet is offering 500-1, it seems worth taking - if you're a gambler.

But there's another risk involved: the "bookie" may not be willing, or able, to pay out. A prudent investor should consider counterparty risk.

More credible warnings

The Bank for International Settlements is joining its voice to the chorus, warning of excesses and a Thirties-style crash, as reported in the Wall Street Journal for 25 June.

Double indemnity

Dan Atkinson in the Mail on Sunday begins with what seems to be praise for the Chancellor's control of the economy, but goes on to note our growing indebtedness. The Bank of England figures he cites, comparing January 2000 with April 2007, show an increase in combined mortgage and consumer debt of around 116%; earnings rose only 31.7% over the same period.

To put it another way, as I calculate it, average indebtedness, adjusted for earnings, has increased by 63.9%. That's an awful lot of future spending power thrown away. The UK appears to have similar problems to the USA.

Crisis report from a very credible source

I looked up an important official today, of whom most of us may not have heard. His job is to review on government spending and report to Parliament. His name is Sir John Bourn and his title is the Comptroller and Auditor General, at the National Audit Office.

Now imagine that this person was so worried about the unravelling of the country's finances that he began touring the country, warning the general public and trying to get the issue onto the agenda for the General Election. I think you'd start to worry, too.

This is exactly what's been happening in the USA, as commented on by Michael Panzner in his website. David M Walker, the Comptroller General, has been playing Cassandra for months. To see the 60 Minutes video about this man, click here.

Could someone tell me the situation here in the UK? We don't seem to have such frank and authoritative public discussion as in the US.

UPDATE

In the CBS video, David Walker notes not only the expense of US medical care, but how many people are uninsured, and the rate of medical error. If you'll also read some of my comments in the globalization thread on Cafe Hayek, you'll see I'm of the view that we should start taking better care of ourselves, rather than trust to Dr Kilpatient.

Planning for the crash

The Contrarian Investor's Journal reveals Part 3 of its thoughts on the crash-to-come, and addresses the dilemma of whether we are to prepare for inflation, or deflation.

I think I agree with the writer's analysis that it may play out as follows:

1. The current inflation will continue until some big scare or crisis starts the run
2. Then there will be deflation, but governments will try to get out of it by printing even more money
3. Printing more money won't work, because people will have lost faith in the currency, so (if you follow the link provided by the writer) we will eventually get to a surge in the price of gold

But we don't know when stage 1 will end, and holding cash may reduce your wealth relative to other assets. So where do you invest?

Buying gold now may mean a long wait before the market comes round to your point of view (if it ever does) and as some (e.g. Peter Schiff) have pointed out, even if you're right, you may find the government forces you to give up your gold, as it did before.

Houses are overpriced, but rather than a general sell-off of real estate I could imagine a long period of house price stagnation, with people staying put if possible. You haven't lost money till you've sold, or the bank has forced you to sell. If you really have nerve, you might sell, live in a tent and buy a bargain when (if!) the housing market tanks - but would your partner agree? Christopher Fildes was suggesting (in the Spectator magazine) moving into a hotel, some years ago - but look at what's happened to London house prices since then.

Some businesses continue even during a depression, if they provide essential services. It's interesting that Warren Buffett and George Soros have both bought into railways recently.

I can't call the play - personally, I am looking to reduce debt and trim personal expenditure, increase cash savings, and otherwise invest with a weather eye on the macroeconomic situation.

Globalisation - is it having an impact on our wealth?

Please see this article on wages and fringe benefits in the US, in which the free-marketers try to show that free trade has not made American wage-earners worse off. I put in a few comments to suggest that healthcare is not a benefit in the same way as cash. I also try to disturb the free-traders' complacency about globalisation.

On the bright side

Time to count our blessings. Here's an essay by Don Boudreaux of the "Cafe Hayek" blog, showing how much wealthier we are than we used to be. And that was 7 years ago.

Nassim Taleb on "Black Swans"

A very interesting article today in The Daily Reckoning Australia by Nassim Taleb, on asymmetric outcomes.

As the Daily Reckoning put it on May 14th, "...the importance of any event is equal to the likelihood TIMES the consequences." Most people underestimate the impact of rare events and so their risk calculations are skewed.

They may also miscalculate the probability of such an event occurring. I believe this was a factor in the 1986 Space Shuttle disaster. As Wikipedia puts it:

...NASA's organizational culture and decision-making processes had been a key contributing factor to the accident. NASA managers had known that [the] design of the [booster rockets] contained a potentially catastrophic flaw, but they failed to address it properly. They also ignored warnings from engineers about the dangers of launching on such a cold day and had failed to adequately report these technical concerns to their superiors.

We could use this a metaphor for the economic system and its technical risks, of which some of our bears continue to warn.

Further concern re derivatives

The Contrarian Investor's Journal continues its series on crash preparation. Part 1 showed how you could lose your shirt on shorts; now part 2 sounds a warning on derivatives - like Peter Schiff, Michael Panzner and Richard Bookstaber.

Michael Panzner: risky lending and expert complacency

Michael Panzner usefully quotes and comments on an article in the Wall Street Journal (the WSJ online edition charges a fee). The piece is by Steven Rattner, a private equity investment manager, and its theme is risky lending. Here are a couple of snippets:

In 2006, a record 20.9% of new high-yield lending was to particularly credit-challenged borrowers, those with at least one rating starting with a "C." So far this year, that figure is at 33%... money is available today in quantities, at prices and on terms never before seen in the 100-plus years since U.S. financial markets reached full flower...

...The surge in junk loans has also been fueled by a worldwide glut of liquidity that has descended more forcefully on lending than on equity investing. Curiously, investors seem quite content these days to receive de minimis compensation for financing edgy companies, while simultaneously fearing equity markets. The price-to-earnings ratio for the S&P 500 index is currently hovering right around its 20-year average of 16.4, leagues below the 29.3 times it reached at the height of the last great equity bubble in 2000.

Some portion of this phenomenon seems to reflect tastes in Asia and elsewhere, where much of the excess liquidity resides: Foreign investors own only about 13% of U.S. equities but 43% of Treasury debt.

I think this tends to support what I suggested yesterday. The tide of money has not risen evenly on all shores - in real terms, equities have failed to keep up. Some bearishness is now already built into the price of shares.

But not, perhaps, sufficient bearishness, so the market is not an accurate measure of the health of the economy. Much investment wealth is in the hands of the over-50s, the golden generation who had good pensions and in many cases got early retirement. They also rode the inflation train on their houses and have paid off their mortgages. At least in my country, many of that generation don't bother to keep a close eye on their investments, because they don't depend on them much. For them, ignorance is bliss.

For institutional investors, ignorance is well-paid. That's putting it a little harshly, but Panzner's piece, and his most recent post, comment on the complacency of analysts and investment managers, suggesting that it may be self-serving (when do they tell you to cash-in?). Besides, many are relatively young, so their optimism is supported by a lack of direct experience of truly dark days, and by the general health and strength of youth. When the market drops, they will look for what they think are support levels and buy-in for the long term. Bad markets often see a transfer of investments from private to institutional investors, I believe; it's a kind of vampirism. The average private investor sells too late, and buys too late.

But institutional support may explain why a major equity descent takes years: it's the jerky learning curve of the naturally upbeat investment manager.

And in any case, the equity market is more often the vic than the perp, to put it in police jargon. The Wall Street Crash was, I understand, the consequence of a banking crisis, itself created by years of monetary inflation, according to Richard Duncan.

So now it's the banks and the money supply we have to watch. And that's why we need to listen to the analysts of the money system, before the investment analysts.

China: a winner you shouldn't back?

This 14 June article by Doug McIntyre for Investopedia explains some of the pitfalls and concerns for those who would like to invest in China.

Another thing to remember is that many Chinese companies make scarcely any profit, which is why their banking system is carrying a lot of poor-quality debt.

The real profit appears to be, not in China's factories, but in transporting their goods worldwide, and selling them: not sheds, but ships and shops. The traders are surfing the wave of wealth out of the West.

How far could the Dow (and FTSE) fall?

Some (e.g. a commenter on one of my May 12 posts) think the Dow couldn't possibly fall 50%, but there is no objective support level for a falling market, it's just a balance between buyers and sellers.

The Wall Street Crash started dramatically, but took about 3 years to complete its decline. On September 3, 1929 the Dow reached a peak at 381.17; by July 8, 1932 it stood at 41.22.

Serious, experienced analysts like Michael Panzner and Peter Schiff tell us that in some respects, the systemic financial problems we now face are indeed comparable to those times. Our advantage is that we have that history to warn us.

UPDATE

More recently, the FTSE 100 reached a peak of 6,930 on December 31, 1999 and a low of 3,287 in March 2003, as shown here. That's a drop of over 52%.

At the time of writing (5:42 pm GMT) it stands at 6,649, but you have to see this in the context of massive monetary inflation; compared with the end of 1999 in real terms, it's lost a lot of ground already. That's why I've suggested that we may already be in a bear market that is disguised by inflation. As in Alice in Wonderland, it has to run quite hard just to stay in the same place.

Chinese billionaires

Forbes China rich list shows that there are already 10 billionaires. Shen Wenrong, who imported the ThyssenKrupp steelworks from Dortmund, is 18th on the list.

James Kynge on China in 2014

If you've read James Kynge's very worrying book "China shakes the world" (2006), you may be interested in an article he published before then, in November 2004. It's in "The Alchemist", which is the quarterly journal of the London Bullion Market Association. Some salient points (though I can't say whether Kynge would say exactly the same things now):

1. The housing market has soared in China, creating massive wealth.
2. "The economy does not look terribly overheated or overbuilt."
3. "Consumer spending - especially on services - is quite a bit higher than official statistics show." (Perhaps this will answer Richard Duncan's recommendation to stimulate demand in developing economies.)
4. Property prices are so high (in 2004) that the rate of appreciation must slow down, which in turn will reduce the demand for steel, aluminium and cement; "a GDP slowdown is in prospect."
5. In 2003, China was responsible for nearly all the increased demand for copper, nickel and steel, but its appetite will endure: "When, and if, China overtakes the US as the world's largest economy, its people on a per capita basis will only be one sixth as wealthy as Americans. They will still be hungry, still cost competitive."
6. The middle class will grow more quickly than GDP; high-tech industrial wage rates will increase; low-tech factories are being forced inland, away from the trading seaboard.
7. China will move from manufacturing (at that time 60% of GDP, versus 30% in the US) towards services and a knowledge economy.
8. China will not collapse, but environmental problems will slow its industrial growth. Land is already intensively used, the north is short of water; air pollution is increasing the burden of health care to the point where the cost may exceed the value of extra factory output.
9. Demographics will also slow China - the over-60s are expected to rise from 11% of the population in 2004 to 28% by 2040. "China may grow old before it grows rich."
10. "China already has too much stuff" - the oversupply of manufactured goods has wiped out profit margins and the banking system is full of debt.

Going back to point 5 for a moment, Kynge doesn't see an end to the trading imbalance. China may decelerate, but it's still going to suck wealth out of the West for a long time.

Marc Faber: consumer spending to decrease

Seeking Alpha's Sunday review of fund manager stock suggestions reveals that Marc Faber expects consumer discretionary spending to decrease:

"He calls for a 10% correction by year-end, with emerging markets down 20%."

That may reduce the monthly trade deficit for a while, but won't turn it into a surplus. China's ultra-low wage costs, combined with what seems to be very loose enforcement of intellectual property rights, are still set to hollow out Western industrial production of all kinds, as James Kynge's book makes abundantly and frighteningly clear.

It's all very well finding ways for individual investors to benefit, but if you haven't got spare money to invest, you can't back the winner in this unequal contest. Without some degree of prosperity, what real peace will our countries have? I'd like to see a credible national economic plan from our politicians.

Pay your bills, or lose your assets

You can rely on Richard Daughty to carry on fighting the brave fight - I really think it's pro bono publico, as I don't see any attempt to turn his work into sales leads for him.

Yesterday's essay continues with the theme of global credit expansion to keep up with the seemingly unstoppable increase of dollars. I suppose that wouldn't be so bad, if it weren't for two considerations:

1. Inflation is unevenly spread, and the 10+ % money supply increase is inadequately reflected in your bank savings interest, so your money is rotting away there. You then have the unenviable task of deciding where else to store your wealth to stop it shrinking.

2. While our governments continue to turn the currency into used bus tickets, the trade imbalances deteriorate, and the international wealth transfers and the world's economic instability worsen.

Will America always be able to make the interest payments on its rapidly-swelling debt? Or is she prepared to see the debt turn into foreign ownership of the economy?

There's a century-old Punch cartoon that shows a plumber sitting on the step of a middle-class house. A passing colleague asks him how the job is going, and he replies that he's taken the house in payment for his work.

Mr Buffett takes a train

Seeking Alpha reports today that Warren Buffett now shares George Soros' recently-discovered liking for railways - perhaps this illustrates a transport energy-efficiency theme.

A contrarian's advice on crash-proofing

The Contrarian Investors' Journal is also waiting for a crash and considering strategies.