Month: January 2012

SOMETHING NEW (a short essay from a long copy devotee)

In the markets and in the world of macro economics everything is related to everything else. Each part of the jig-saw puzzle to assist in foretelling the future in even a hazy way, is incremental, and scattered pieces of data and interpretations when presented together can add perspective to deeper and broader articles floating about in our world of information over-load.

UNCLE BEN BERNANKE

Ben Bernanke, current Chairman of the US Federal Reserve and successor to the very unsuccesful Alan ‘Bubbles’ Greenspan has expressed the view that the Fed should be more transparent. Mr Greenspan only became lucidly transparent after his retirement when he said that some of his economic premises were wrong. In relation to transparency generally, though, some have said that just like the British sausage the less you know about its ingredients, the better it will taste and the safer you will feel.

Uncle Ben has the dual mandate of stable prices (low inflation) and full employment. With the official employment number hovering just under 9% it is reasonable to expect that inflation will be subdued as less jobs gives less income and lower demand. In the US economy, indeed the world economy, there is excess capacity and an abundance of goods and services and inflation is not a dominant worry for a central banker. But growth is, and bank lending is, and bank liquidity is, and bank solvency is. The world is deleveraging and the middle classes of the world have run out of ammo to fuel demand as they engage in paying down debt.

So in this new mood of transparency Uncle Ben has said that the Federal Open Markets Committee has decided that short-term interest rates will be kept at a near-zero level for another 3 years to promote economic growth and reduce unemployment. Presumably interest rates will only rise during that time if he is succesful and the economy rebounds in a meaningful, sustainable fashion. Uncle Ben has also said that the Fed may also re-start a bond-buying program if the economy remains sluggish. In passing and in context of his 3 year view on interest rates he also said "It’s certainly possible we will be either too optimistic or too pessimistic".

There has been huge condemnation of this Fed development. Comstock Partners said: "In our view the Fed’s new policy is an act of desperation rather than something to celebrate. The FOMC has used all of its conventional weapons and a lot of unconventional ones and is essentially out of ammunition. The banking system is swimming in excess reserves that it is not using—-adding more won’t make much of a difference. This is a classic liquidity trap where further easing will not be much help. The stock market strength assumes that the economy is getting stronger and that company earnings will remain at elevated levels. We think that this will not be the case, and that the market is subject to substantial downside risk."

Doug Noland author of the blog ‘The Credit Bubble Bulletin says; "It has been labeled an intellectual exercise and ridiculed as "intelligentsia." I’ll stick defiantly to the view that it remains one of the most important issues of our time: Are the Treasury and government-related debt markets part of a historic Credit Bubble and global financial mania? There are reasons why Jean-Claude Trichet over the years repeatedly stated "the ECB would never pre-commit" on interest-rate policy. The Federal Reserve this week moved further to the opposite polar extreme, essentially pre-committing to near-zero rates through late-2014. The ECB has historically believed that market speculation based upon future policy expectations works to foment market excesses, imbalances and attendant fragilities. In contrast, the activist Federal Reserve believes that it has a fundamental obligation to intervene and manipulate to achieve market outcomes the committee believes will spur growth. Unprecedented operations back in late-2008 took the Fed’s balance sheet from about $900bn to $2.2 TN. We were assured that the Fed had an "exit strategy." I’ve always presumed "no exit," and here we are today with Fed holdings at $2.9 TN. The economy is expanding, financial markets are strong and consumer price inflation is rather undeflationary – yet Dr. Bernanke is again signaling he is prepared for additional monetization."

The bottom line for us is: Exercise caution, don’t over-commit to equity markets, be careful, be selective, be prepared to jump on and off the equity express on frequent occasions. There are a lot of false prophets about and until the European banks write-off their bad debts, an abundance of false profits. Many of the false prophets seem to have just left Davos.

 

DAVOS

The great minds that assemble each year at Davos to discuss world affairs and who seemingly were unaware of Long-term Capital Management ( a speculative, model-based hedge fund rescued by the Fed in 1998), the tech-telco bubble/ crash, The Global Financial Crisis (Lehman Bros etc and the ‘too big to fail gang’), sovereign debt fiascos (from Iceland to Italy to Greece, Spain and Portugal), the current European Banking problems, the recent Corzine MFS debacle, have just concluded their 42nd meeting.

Judith Sloan who writes for The Wall Street Journal and The Australian, and who attended the conference said today " I can’t wait to get home, to a place where there are more rational and sensible thinkers per head of population than I ever realised." Ms Sloan’s home is Australia.

Last week in an op-ed piece in The Australian she said: "The meeting (on global warming) literally drips of political correctness. Much of the language is impenetrable, it is English by the way. According to the blurb for the meeting ‘the net result will be transformational changes in social values, resource needs and technological advances as never before. The necessary conceptual models do not exist to develop a systemic understanding of the great transformations taking place now and in the future’. "

The bottom line for us is: Beware of geeks bearing gifts, those who gave us the current chaos are struggling to understand the questions and almost certainly are incapable of generating the solutions.

 

FOURTH QUARTER US GDP

Fourth Quarter US GDP came in at 2.8% which on the surface looks to be a good result when compared with Q3 at 1.8%. BUT the CPI deflator came in at 0.4% (the lower the number the higher is real GDP) when other CPI numbers were as high as 3%. However, the real sting in the tail was the fact that 1.9% of the GDP number related to a rebuild of inventories which now are an over-hang for Q1 of 2012. Given that 15 out of 54 economists from The Wall Street Journal Economics Panel (28%) are forecasting Q1 2012 GDP under 2% it seems apparent (as Uncle Ben seems to be saying) that the US economy is still subdued, sluggish, less than robust, sombre, less than sunny, or whatever soft language you might like to use.

The bottom line for us is: Expect a market correction soon and volatility to continue amidst arguable and ambiguous macro statistics and political pronouncements.

 

 

OUR FORECASTS FOR 2012

Our reference indices are the SP500 (SPX), our global proxy, and the All Ordinaries index (XAO).

Our 2011 forecasts were about 95% accurate for the SP500. and about 80% accurate for the XAO, the former being regarded as satisfactory and the latter as unsatisfactory.

We regard index forecasting as essential but relatively useless for investment performance in modern markets which have vacillated over recent years between dynamic and chaotic. Eisenhower said: "In preparing for battle I have found that plans are useless, but planning is indispensable."

Ecinya prefers to work around fundamentals related to maintainable earnings yield, company and economic themes, market context and market action itself, both in a technical and quantitative sense. We have a small number of confidants and colleagues of independent and constructive mien.

OUR 2012 FORECAST IS: The SP500 will have a range of 1120 to 1350 finishing the year close to, or above, 1350. The first half will be volatile to the downside and the second half volatile to the upside.

The XAO will have a range of 4000 to 4950, closing the year close to the high end of that range. The first half will be volatile to the downside and the second half volatile to the upside.

Our major Black Swan event, which is not priced into these forecasts, is war against Iran from the US and Israel, and possibly and preferably (should it happen) joined by other Arab countries.

 

BULLISH CASE vs BEARISH CASE

The bearish case is that Europe is already in recession and about to enter a significant recession as the banking system is at a point of cataclysmic failure. The European recession will flow on to America and then to China where excesses in their banking and property markets will surface. Then global recession impacts on Australia with falling commodity prices turning our two speed economy into a no-speed economy. This case has zero belief in fiat money and apparently believes that debt levels are incapable of cyclical solution.

The bullish case is that paper money works, and targeted reflation and targeted austerity works. The nascent American recovery gathers pace and America re-invents itself and becomes again a beacon for the world. China has a soft landing. Europe muddles through and addresses some of its structural problems in work and welfare. A sound bail-out institution works in the short term. Even in a softening of world growth scenario our Reserve Bank has room to move.

The bearish case involves a substantial suspension of history in relation to economic, market and political cycles.

 

WHERE DOES ECINYA RESIDE IN THIS DEBATE?

We are in the bullish camp but hoping that our natural optimism does not blind us to any negatively evolving outcomes. We want to stay watchful and alert. Our major fears are Iran, the current Australian Federal government and the faint possibility that America is ungovernable. We believe in cycles and waves and the bearish cycle we consider will be near to ending during the second quarter of calendar 2012.

However, positive outcomes also depend upon a belief in paper (fiat) money. Debt is not the problem per se, rather it is that current debt levels resulted from extreme misallocation of resources with consumers bidding up house prices, running down savings, investors leveraging their entry into share-markets, companies paying too much for assets and expanding unwisely, and governments embarking on unaffordable welfare and warfare expenditures.

Paper money represents purchasing power and is the price that is paid for people to work in the production of goods and services. Paper money keeps people off the streets and rewards them for useful work and enterprise.

According to the December 31 issue of The Economist, champions of ‘Modern Monetary Theory’ are calling themselves neo chartalists. They believe "that because paper currency is a creature of the state, governments enjoy more financial freedom than they recognise. The fiscal authorities are free to spend whatever is required to revive their economies and restore employment. They can spend without first collecting taxes; they can borrow without fear of default. Budget makers need not cower before the bond market vigilantes. In fact they need not bother with bond markets at all."

Double entry book-keeping (developed in the 11th century) has as its basic postulate that for every debit there is a corresponding credit. The credit entry of current relevance is debt which is being spoken about incessantly, almost as if it were incest. The corresponding debit is factories, mines, and public and private infrastructure, the expenditure which is not being spoken about at all. True that public and private assets were inflated in pricing terms (electricity privatisation, the Myer float, certain acquisitions by private equity, the share market generally, housing etc) but a lot of that work-out has occurred and is occurring as discounted assets are removed from bloated bank balance sheets and re-possessions feed off the carcass of past folly.

Ecinya is far from sanguine about excessive debt. In our 2006 Overview we penned the following – "The new global and urban myth – debt does not matter: That public and private debt doesn’t matter is a very substantial un-truth. A very substantial un-truth is a fallacy, a lie. The fact that many believe a lie to be true does not change it to truth. To sustain a good lie, recognisable elements must be present to give it the aura of truth, the character of truth, so that well intentioned, honest, well regarded commentators can perpetuate the fallacy and make it grow profitably for a wide range of beneficiaries – bankers, politicians, stock-brokers, real estate agents, and other brokers and commission salesmen. When these persons are getting disproportionately richer and manufacturers of real goods and services (weapons of war excluded) are getting disproportionately poorer, an adjustment is generally not far away. A pervasive lie will not die from a single gun-shot wound to the head, but from a thousand pin-pricks."

The main dangers we see for ourselves is Iran, continuing Federal government incompetence, and the fact that America may well be ungovernable in the short to medium term.

We will be watching –

• Bill Evans (Australia) and Paul Kasriel (USA) on the economics front.
• Australian credit statistics.
• The SP500.
• The ShanghaiA index.
• The copper price.
• Developments in the American energy sector.
• China generally.
• Our market quant model.

 

EXECUTIVE SUMMARY

1. Australia needs a new Federal government. The current trends are unmistakably bad. The middle class is pressured. It is a worry that Ecinya regards Mr Swan as our second worst post WW2 Treasurer at a time when he carries the trophy for World’s Best Treasurer.
2. The opposition needs to lift its economic game and credentials. Scott Morrison or Malcolm Turnbull should become shadow treasurer. Paul Fletcher could assume a more prominent role in Communications & Media. Good policy work is being undertaken by Andrew Robb, but if populism triumphs over policy our exposure to negative external developments moves to major risk level.
3. The Henry Committee should be re-convened and its terms of reference widened to include the GST. About 80% of the Henry Report was ignored and only the expedient positions embraced as the budget surplus had been totally squandered.
4. Industrial relations has regressed and needs to be reformed. Proper reform would assist both Unions and the nation.
5. The world needs more work, less welfare, and less warfare. The modern democracies have moved too far to the left. Unemployed youth, poorly targeted and poorly administered welfare, is sapping economic opportunity. Accumulated problems from warfare (Iraq, Afghanistan) have stressed sovereign budgets. The left believe in legislation and the right have a diminished ethical base, so there is fault on both sides of the debate. Wikipedia identifies about 30 wars in every decade since 1945. Refugees are developing into an economic problem rather than just a serious social problem.
6. The current ownership of the US Federal Reserve needs to be disclosed, its role and relationship with the federal government and Wall Street needs to be examined. It should become more independent.
7. Europe and America need a large dose of tax reform.
8. America needs a President who is more of a manager and less of a messiah. The George W Bush swing to the right was an ambiguous failure and the Obama experiment has failed.
9. The jury is still out on US state and municipal insolvencies.
10. ‘Balanced free enterprise’ needs to replace ‘capitalism’ and ‘socialism’. The role of government should be examined in terms of its share of national economies. We target inflation but not the exponential growth in government expenditures.
11. ‘Beneficial trade’ should replace ‘free trade’.
12. Elections should be funded through an Electoral Bank in the democracies to mitigate crony capitalism and crony socialism.
13. America can re-invent itself and Europe should muddle through after it creates an enduring bail-out institution before addressing some of its structural problems.
14. The Euro treaty and constitution needs to be re-visited. It is interesting that the Italian technocrats seem to be receiving favourable reviews.
15. China should seek to become an adult member of the international community in word and deed. For our part changing the name of The Chinese Communist Party to ‘The China Central People’s Party’ would be a sound initial step. Removal of the word ‘communist’ would mitigate cheap shots from the radical American right. China is not yet ready for democracy.
16. America in particular and the world generally needs a large dose of eduction and infrastructure spend.
17. The world generally needs a genuine debate on taxation, population, infrastructure and the way we govern ourselves.

 

LOOKING BACK TO 2010 AND 2011

We captioned our 2011 Insight Overview paper as "A year of survival and opportunity, but little room for complacency as the march of folly continues. The year will be essentially flat, but with sufficient volatility to allow traders and active value investors to outperform market indices."

During 2011 major Insight articles issued as follows:

• 28 January: We love our sunburnt country, but we should aim for solvency over the cycle.
• 15 April: Ronald and Kevin: Two failed revolutions separated by history.
• 18 July: The real GFC – Government Facilitated Chaos.
• 12 August: Crony capitalism – capitalism’s cancer. Crony socialism – socialism’s endemic malady.
• 29 September: Tax Reform: STUPID – Silly Taxes Upset proper Industrial Development.
• October 7: Is austerity or reflation the pathway to economic recovery?

Our 2010 paper was captioned "Our view of the year ahead" . (How’s that for simplicity or lack of imagination?). Our message which carried over into our 2011 deliberations as well as aspects continuing into 2012, was –

"Though we regard the primary trend for 2010 to be UP, volatility will be a feature as the recovery will be complex. Most of the forecasters will have their moment(s) of directional accuracy, but will not be right for the entire year. Distrust any forecaster who just gives you a year-end index figure, which is a simplistic and lazy forecast, and relatively worthless.

2010 will be a difficult year simply because we had a complex recession with misleading and deceptive behaviour from many institutional and market related sources. Political correctness, self-interest, and convenient informal conspiracies have combined over the past decade to induce complacency and to mute criticism of behaviours that were near to fraudulent at worst and criminally careless at best, in relation to this credit crisis and the last tech/ telco crash. These institutions include bankers and brokers, government ministers, long-term fund managers, hedge funds, companies, the accounting profession, ASIC, the ASX, the IMF, and central bankers. Thus the natural tendency of market participants and informed commentators towards scepticism has been in retreat, and, to varying degrees, we have been slapped in the wallet by yet another harsh dose of reality. The commentariat has polarised into rampant bulls on one side of the debate, and negative zealots on the other. The response of the thoughtful should be to develop a strategy around viable data, consonant with an effective review and monitoring process. Only the nimble can outperform the swirling mass of ‘noise’ that hits us on a daily basis."

During 2010 major Insight articles issued as follows:

• 17 April: Outperformance! Seeking the holy grail.
• 26 April: Overcoming the chaos with Kotlikoff
• 5 May: KEN"S CRUSADE – searching for TRUTH in the tax reform debate.
• 10 June: Is that opportunity knocking, or is it the debt collector calling? A look at fiat money.
• 1 October: Bull or bear? Not quite the right question.
• 22 October: Paul Volcker – reasonable, rational, largely ignored. Why?
• 3 December: David Murray – a bridge too far.

 

A WORD ON FORECASTS, SOME NUMBERS FROM WESTPAC, AND ENDURING STATEMENTS FROM IAN MACFARLANE AND PETER WALSH

A forecast is a prediction and calculation related to future events. The future is difficult to predict both in relation to time and dimension. Therefore, the underlying hypothesis has to be set out so that as events unfold and time passes, the forecasts can be measured to provide confidence or provoke action.

An hypothesis is according to our Collins Dictionary "A suggested explanation for a group of facts or phenomena, either accepted as a basis for further verification or accepted as likely to be true".

According to Westpac Economics the world was in recession for calendar 2009 with world growth running at negative 0.7%. The 2010 recovery resulted in world growth of 5.1%, about equal to the pre-crisis growth rate of 5.4% for 2007. Westpac’s estimate for 2011 is 3.9% and their forecast for 2012 is 2.8%. (Note that global growth under 2% is generally viewed as a global recession)

The problem we have is that the 2010 recovery was largely synthetic with massive stimulus coming from America and significant stimulus from elsewhere, including Australia where the reaction to crisis was clearly political and dysfunctional (education, climate, taxpayer hand-outs). America still has not addressed its structural and systemic problems.

In relation to Australia the 2010 and 2011 calendar years will yield growth around 1.7%, well below trend of circa 3.2%. Westpac have European growth at 1.6% for 2010 and 2011 and negative 1.0% for 2012. Over both 2011 and 2012 growth for the USA is 1.7%.

Ian Macfarlane, former Governor of the Reserve Bank, in June 2005 said; "The principal contribution that monetary policy can make to economic well-being is to maintain low and stable inflation. I think it is true to say that if you wished to forecast the path of the Australian economy, and you were able to have fore-knowledge of only one economic variable, the one you would choose is the path of the world economy. That is not to say that we have no influence over our own destiny – we can make the situation better or worse than it would otherwise be – but we cannot escape the influence of the world business cycle and the other factors that feed off it."

Australia has a narrow export base and a broad and deep import base and it is important that domestic budget surpluses be preserved and that budget deficits be shallow. The Rudd-Gillard-Greens coalition government has departed from this wise counsel and HAS made things ‘worse for itself’.

As our sovereign debt continues to grow at an almost alarming pace (refer Insight article 3/12/2010 ‘David Murray – A bridge too far’) it seems that the governments since 2007 have also ignored sound advice from Peter Walsh, Finance Minister under Robert Hawke. He said, in 2003, criticising his own side of politics: " All countries which accumulate debt and habitually run big current account deficits are vulnerable. And for many centuries societies have been susceptible to irrational booms, South Sea Bubbles, tulip bulb booms, and dot com busts. But no central bank can offset the cascading effects of bad government policy."

 

WISHFUL THINKING

Wishful thinking is the enemy of hard work. Undeterred, we set out below a fulsome list of our wishful thinking for 2012 for Australia –

• A new federal election is held as soon as possible.
• Extension of the Federal parliamentary term to a minimum of 3.5 years and a maximum of 4 years, later moving to a minimum of 4 years and a maximum of 5 years.
• Incorporate and activate Australia wide an Electoral Bank to fund both state and federal elections
• Lower the carbon tax or abolish it and move to a direct action model using viable technology.
• Modify or abolish the current Mineral Resources tax.
• Re-convene the Henry Tax Committee and include the GST in its brief. Come up with efficient solutions to abolish payroll tax, the anti-economic velocity and paperwork problems of capital gains taxes, and inefficient state taxes.
• Conduct an enquiry into retail rents and the extent of the subsidy to major supermarkets and department stores.
• Conduct an enquiry into the overall impact that the monopoly supermarkets are having on Australian agriculture.
• Develop a long-term plan for water storage and flood mitigation.
• Publish a feasibility study and progress report on the National Broadband Network. This is a sleeper that may well be a disaster.
• Disclose in a single paper the costs of our border protection/ refugee policies.
• Imposition of a $5 fine on politicians who use the word "fair" and a $10 fine on the phrase "fair and balanced" with the proceeds going to a charity nominated by Don Watson, the author of "Death Sentence – the decay of public language".