Prologue
In preparing for battle I have always found that plans are useless, but planning is indispensable.
Dwight D Eisenhower, circa 1942
To assist yours, and our, intellectual navigation we start with our summary conclusions for the year ahead. The analysis then follows.
SUMMARY CONCLUSIONS
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.
Please read the About Ecinya and Market Wisdom pages as refreshment for the year ahead.
Macro Market Outlook and Assigned Probabilities (as at 13 January 2010)
- 2% probability…..Economic recovery, new bull market takes out previous highs.
- 70% probability….Economic recovery with several double-digit retracements, one possibly close to 20%.
- 50% probability…..Recovery, but muted subdued advance.
- 40% probability…..Double dip recession, more stimulus and bail-outs required.
- 30% probability…..Secular bear-market continues with index levels going below 800 and 4000: Current retracement began at circa 1550 for S&P 500 with 1100 as the top of the downtrend channel, corresponding with XAO equivalents of 6800 and 4500.
- 6% probability….’The great recession’ morphs into ‘the great depression’. This is the Robert Prechter et al view.
‘Probability’: A measure of the relative likelihood of occurrence of each of the above observations. The 6 values above do not have to add to 100. For example in 2 above there is a 30% chance that something else will happen; in 1 above a 98% chance.
STRATEGY FOR 2010
Because the XAO is 55% above its 2009 lows and only 28% below its 2008 highs, the ‘bargains’ are not in abundance. Therefore –
- Stock selection is vital.
- The earnings season starts end January and many companies have to overcome the dilutive impact of heavily discounted share issues.
- Risk management is essential, look for macro turning points.
- Trade around the edges of value propositions.
- Try to find some takeover or recovery stocks.
- Focus on major resource stocks and fewer speculative stocks.
- Have a small bit of speculative money in established bio-techs and climate related situations.
- Look for industry rationalisation in the media sector.
- Have some dollars in property (oversold) and infrastructure.
- Keep your eye on $USD index ( China, USA and India expected to provide 60% of the world growth estimates for 2010).
THE THREE ECONOMIES
We have long been aware of the role that government action, intervention and policy play in stock-market outcomes and have warmly embraced the 2003 view expressed by Paul Krugman that: "To talk about economics requires more and more, that one write about politics."
In looking at economics, the traditional thesis has been to talk of two economies: the real economy and the symbol economy. The real economy is the production of goods and services; the symbol economy is money and credit. We have always believed that the latter existed to facilitate the former. However, with the growth, in particular, of derivatives and a greater global focus on equities and investment generally, the emergence of third economy distortions have complicated the process and the analysis. It seems rather ironic as we embrace the pressures being placed upon various economies by the aging of the baby boomers that we spend so much time keeping people alive well beyond practical dates and even beyond their own desired lifetimes.
What then is this third economy? It is ‘the political economy’, an expression that has emerged over the past few months and reflects a much more targeted thesis than the very useful Krugman generalisation. The symbol economy and the political economy tails oft wag the real economy dog.
An easy example is the Iraq war where even Mr Greenspan accidently said "It was all about oil". The Bush, Cheney, Blair, Howard nexus said it was about WMDs and, later on, ‘freedom’. Greenspan later withdrew his remark. But the Iraq war had a profound impact on oil pricing and price volatility as well as blowing a big hole in the American domestic budget deficit. Additionally, the USA subsidises Israel, its major Middle Eastern ally, and some Arab States, to enable them to purchase the defence hardware and software that the American defence industry excels in producing, and which employs a vast number of Americans across many states.
Dwight D Eisenhower famously warned of the dangers of ‘military industrial power’ on 17 January, 1961. Ecinya has often written about the US$1.5 trillion global defence budget of which America spends just over half, and how this expenditure is a misallocation of global resources.
At a less dramatic level, but more relevant to the world economy and of more pervasive interest to all of us as tax-paying citizens, we are currently seeing a major shift towards government increasing its share of GDP in both the developed and emerging world. In the USA, government share of US GDP was about 17% in 2001 and in the latest GDP estimates is running at 28%. The story is broadly the same in the UK and Australia. Europe can generally be excluded from this analysis as they embrace a more socialist economic model and, apart from Germany, allow large scale tax evasion in the general populace outside of the major capitals.
In Australia, Dr Ken Henry, Secretary to the Treasury, in giving his November 2009 address to the Whitlam Institute Symposium said that before Whitlam in fiscal 1972 government expenditures were 18.9% of GDP. In the last Whitlam budget (1975) expenditures had moved to 24.8% of GDP and expenditures are currently running at circa 26%, having dropped to about 23% in 2001. Given that health, education, and social security and welfare, account for 29% of government outlays and around 6% of GDP, Dr Henry’s statement that " The Whitlam government was, therefore, responsible for an enduring increase in the size of government. That is, close to 6 percentage points of GDP expansion in government expenditure during the Whitlam Government has never been reversed. And I think I can safely say that it never will be."
ECINYA’S MESSAGE: The political economy is now running at 25% of the total economy with the shortfall from lower tax collections being funded by higher debt and deficit levels. This appears to us to be dangerous economic and social folly and will impact on economic growth, employment, inflation, and result in higher interest rates and higher personal tax collections. One of the interesting features of taxation systems generally is the extent of ‘hidden’ taxes e.g. payroll tax, workers’ comp etc
THE BIG MACRO QUESTION…. can voodoo economics get us through the slow-down and create a sustainable basis for growth?
Background quotes
Research is to contemplate the possibility that, intuitively, you may not know the answers, and worse still, you may not even know the questions. Information insightfully interpreted will help avoid being caught in a position where you can lose a lot for reasons not understood. Try to avoid making the facts fit the theory, especially in relation to timing.
Ecinya Investment Rule #2/ 10, 1997.
In relation to The Bank of England don’t forget we are not talking about a new institution on a learning curve that is just a few years old, but rather a 300 year old institution that knows full well the ins and outs of the banking system that it created over the centuries that exists primarily to turn everyone, including the government, into debt slaves. The economic press instead of holding the Bank of England to account is praising the bank for its actions in preventing an economic depression.
Nadeen Walayat, Market Oracle Co UK, 31/12/2009
We have a world of fiat money – that is, money which can be created at the whim of our central bankers, as distinct from one based on gold, for example, and if their whims are wayward, the results will be disastrous, without any other conditions for disaster being required except the normal human responses and frailties.
Andrew Smithers "Wall Street Imperfect markets and Inept Central Bankers", late 2009.
Clearly the central bank of Zimbabwe has overdone it. But if the central bank of the USA has overdone it few seem aware of it. The secret is to give people more money, but not so much more that they realize all they’re getting is pieces of paper. Paper money may be a fraud, but it still represents purchasing power. When more units of it appear, people assume they have more purchasing power. And when they spend more, the merchants think there is more demand and increase production.
Bill Bonner, "Empire of Debt", 2007.
Ecinya comment: Debt is said to invoke necessary discipline, simply because you have to pay it back, or risk foreclosure, or a credit downgrade which increases the cost of future debt. Private debt is said to be more disciplined than public debt because it requires you to earn income and profits to service your debt obligations, including interest payments. Public debt on the other hand usually results in governments raising taxes, or more debt, in the hope that inflation over time, or an election loss, will hide their profligate behaviour. The problem with governments, of course, is that they face the electorate on a regular basis which encourages unsustainable pre- election policy followed by the need to pay for it post-election. A lot of the cost of poor policy and poor policy execution is higher interest rates.
Hence the ‘voodoo economics’ of which we speak is that Ecinya remains to be convinced that de-leveraging the private sector by leveraging the public sector is sound economic policy. Australia has gone from a domestic budget surplus of just under 2% of GDP and zero debt to a domestic deficit of 3.6% and 19% govt debt to GDP ratio, respectively. The domestic deficit is a swing of $50 billion. Wow! Though these deficit numbers are relatively low and well short of the USA at 10% and 55% respectively, it still means that we are exposed to any downturn in the global economy and vulnerable to the unexpected, such as event risk and, say, an oil price spike.
Australia has not done anything in relation to substantive industry policy (other than trade white papers that omit any reference to imports) for about two decades to mitigate our persistent trade deficit. Rather the stimulus package (that ‘saved’ us from recession) and government policy on work-place ‘reform’ has entrenched us as a nation of chronic importers. Because of inflexible and unrealistic labour laws and high taxes on employment, Australia will produce about the same, but using less labour and/ or creating more welfare recipients. An import is a job created abroad.
FUNDAMENTAL FEAR LIST FOR 2010
- America economic aggregates, and policy settings; negative trends in employment, current account and domestic deficits.
- The aftermath of American foreign policy history and its implications for global resource allocation and growth.
- The global economy and the possibility of growth rates disappointing as stimulus is withdrawn.
- The lead into various elections around the world that might encourage profligate fiscal behaviour (UK, Australia, and US mid-terms are on the horizon).
- Higher global and local interest rates, particularly the latter, in context of rising inflation.
- The unintended consequences of additional stimulation.
- Another major institutional failure in the USA.
- A downgrade of US debt.
- China having a few problems which are currently overlooked such as slowing exports, failures in the small business sector, and non-performing bank loans.
- Rising taxation levels. In Australia this will be euphemistically called ‘tax reform’.
- A break-out in local wages.
- Unemployment staying persistently high.
- Commercial property values globally.
- Municipal and state failures in the USA . The 10 most troubled states in the USA are Arizona, California, Florida, Illinois, Michigan, Nevada, New Jersey, Oregon, Rhode Island and Wisconsin. Other states, not far behind, are Colorado, Georgia, Kentucky, New York and Hawaii.
- US local bank failures (144 banks have failed since December 2008 and more are said to be at risk).
TECHNICAL AND MICRO WATCH LIST FOR 2010
We want growth to go up, and will be watching nominal growth rates closely. Inflation in a 3-4% band does not worry us provided growth is above 3-3.5%.
- US dollar, via the US$ index.
$USD (stockcharts).We want to see the $US rise to appease the Chinese and other lenders to the USA, and as a measure of recovery of confidence in the US economy.
- Shanghai composite index.
Up we hope, relatively stable.
Looking for a low of 950-1000, but a year-end close of circa 1225.
Hope to see them playing a meaningful role in world affairs. Would love a change of name for the Chinese Communist Party to ‘The China Central People’s Party’. Suspect that some of their economic and banking numbers are rubbery.
Hoping for less than $80-$100 range. Iraqi oil seems interesting, but it is in Iraq, and that’s a problem.
Would like to see muted price action. Think current action is more to do with risk asset speculation than safe-haven status.
Swing to the centre desired from current left swinging to appease Democratic Party base.
Ecinya agrees with Peter Walsh (former Federal Finance Minister) that Mr Rudd is an ‘economic illiterate’. Bad policy positions exacerbated by even poorer execution.
Like to see it go up as copper is Mr Industrial Production.
We expect a few retracements, with the first being in the first quarter, particularly if the S&P 500 heads for around 1150 to 1180. The sooner the correction, the better.
WORLD GROWTH IN 2010
SOURCE: "The World in 2010", The Economist, December 2009
Each year The Economist publishes a world outlook issue (145 pages this year) which includes statistics on 82 countries. This is a useful view of the consensus and the IMF view at the time of publication.
The Economist is forecasting 2010 world growth, in market exchange rate terms, of 2.5%, a tad below trend of 3.0%, with 2009 growth having been estimated at negative 1%. World GDP for 2010 will total about $US 59.4 trillion and the world growth aggregate will be about $US1.5 trillion, of which China will contribute 30% ($443 bil), the USA 24% ($348 bil), and India 6% ($87 bil). Thus 3 countries will be responsible for 60% of world growth in 2010. Australian growth is forecast to be 1.7%, but Ecinya believes this is at the lower end of the range, thus we are opting for around 2.8%, which is close to trend at 3.2%.
EVENT RISK
Our forecasts and conclusions take no account of event risk such as terrorism and wars that might impact on the psyche of consumers and/ or the oil price or currencies. Troubles still abound in Afghanistan, Pakistan, Iraq, Iran, Israel and North Korea. We take some comfort in the fact that Mr Obama is not George Bush and this was recognised in him receiving the Nobel Peace Prize in anticipation of what he might achieve. But the cacophony that is the American right more than makes up for George Bush’s absence (Palin, Hannity, Limbaugh, Beck etc). America has fought wars more successfully on its home soil than abroad (The American Civil War and The War of Independence both won by Americans on time and within budget) and made many errors of deployment and judgement in WWII, North Korea, Vietnam, Iraq and Afghanistan. America seems to rely more on overwhelming force than skill. There appears to be frequent break-downs in intelligence and homeland security.
In looking at terrorism both Mr Bush and Mr Cheney’s views appear to emanate from the peculiarly adolescent trough of the evangelical red-neck right. This was eloquently summarised by Chris Patten in his 2005 book "Not Quite the Diplomat: Home Truths About World Affairs’ :
So, we all hate terrorism. But we in Europe are also uncomfortable with the one-dimensional nature of the debate in some American quarters; the unwillingness to accept that terrorists might on occasion use abhorrent means to pursue ends that we may or may not agree with, but which are susceptible to reason and whose causes can be addressed without going to war. It is as if any discussion of the causes of alienation and hatred was evidence of appeasement. The idea of a world divided between good and evil – between us and them – sits uncomfortably with most Europeans.
PREDICTIONS GENERALLY
Background quotes
In the long run the stock-market indices fluctuate around the upward trend in earnings per share. Human behaviour cannot be predicted. Distrust anyone who claims to know the future. Chaos is not dangerous until it begins to look orderly.
Ecinya Investment Rules #6 & 7/ 10, 1997.
Global financial markets have a lot of moving parts, and it’s very difficult for anyone to fully encapsulate all the factors that are weighed into any single forecast. That’s why it’s very important to keep an open mind about all possible outcomes, while continuing to gather the facts, conduct analysis, and form an opinion, and conceding one could be wrong. While the general consensus believes the Fed won’t lift rates until late in 2010, it’s the contrarian view which might prevail next year, with the Fed hiking short-term interest rates sooner rather than later. Former Fed Chief Paul Volcker, said on Oct 15th, it "was difficult, but necessary, for the Fed to start draining the billions of dollars in liquidity even while unemployment remains high as the US battles out of recession. You have to act against what seems like common sense. If you wait, it’s too late," he warned. Two-months later, the Bernanke Fed is still signaling ultra-low rates for an extended period of time.
Gary Dorsch of Sirchartsalot, 16/12/2009
It can fairly be said that the chain of catastrophic bets made over the past decade by a few hundred bankers may well turn out to be the greatest non-violent crime against humanity in history. They’ve brought the world’s economy to its knees, lost tens of millions of people their jobs and homes, and trashed the retirement plans of a generation, and they could drive an estimated 200 million people worldwide into dire poverty. In other words, never before have so few done so much to so many. And has there been even one major, voluntary resignation by an American financial executive? One sincere apology? One jail sentence? Why the American public hasn’t taken to the streets in revolt is a mystery that can be linked to our inherent belief in the virtues of capitalism.
Graydon Carter Editor Vanity Fair, June 2009 issue. This magazine is an excellent source of economic and political material
Firm predictions are out of the question. The future depends on the policy responses the financial crisis will provoke. But we can identify the problems and analyse the policy options. We can also make some firm predictions about what the next era will NOT look like. The post-World War ll period of credit expansion will not be followed by an equally long period of credit contraction. Boom-bust processes are asymmetric (not identical) in shape: a long, gradually accelerating boom is followed by a short and sharp bust. Consequently, most of the credit contraction can be expected to occur in the near term…….. Congress has left the conduct of policy largely to the Federal Reserve. This has put too much of a burden on an institution designed to deal with liquidity, not solvency, problems.
George Soros "The New Paradigm for Financial Markets. The Credit Crisis of 2008 and what it means."
WHAT WE LEARNED FROM THE 2009 CREDIT CRASH REMEMBERING ALSO THE LESSONS OF THE 2000 TECH/ TELCO CRASH
- In summary, not much really, except that Ecinya is inclined to be somewhat too optimistic on occasions. We were very pleased to have called the March 2009 bounce with a high degree of logic and accuracy, and to have anticipated most of the carnage of 2008.
- Countries must retain sovereignty over their banking systems.
- An independent central bank is an indispensable check and balance mechanism – additionally, APRA worked. The US central bank is not independent as are very few American institutions, being too closely aligned to the political establishment.
- American investment banks and hedge funds are untrustworthy.
- The US Treasury Secretary should be viewed with caution, especially if he emanates from Wall Street. Paul O’Neill, ex Alcoa CEO and not of Wall Street, got the sack for being an honest man.
- Auditors and independent directors are not fully accountable to shareholders.
- Commercial banking and investment banking/ stockbroking are a bad mix.
- Global forums are dangerously beguiling and need to be approached with care as they inhibit your sovereign status and thinking. The IMF is sleepy and belatedly competent. The UN is poorly structured and inept.
- America needs a fundamental change in attitude, having adopted the ugly twin sisters of crony capitalism and worship of celebrity status. Mr Obama and his team needs to be lesser celebrities and greater managers.
- Everywhere, language has become imprecise, euphemistically misleading and deceptive. Spin is rampant, a bushfire destroying social and commercial values. Be wary of cant. Television is dumbing down the populace.
- Australia came through the global financial crisis because of the Hawke-Keating-Walsh-Howard-Costello legacy. Mr Rudd has extinguished that legacy and extracted little or no sustainable value from it.