Category: Insights

"My genuine concern for Australia is to pay very close attention to the macro-economic and micro-economic issues that will determine our future. Ideological objectives along with philosophical goals will not get us there and being lucky will not be enough. The successful leaders of today must understand that their power rests with the people for whom he or she is responsible. To tap that power the leader must abandon the old baggage of dominance, control and self-centredness."

The Hawke and Keating governments, for example, are singled out as particular milestones of national progress. Both leaders represented a ‘new breed’ of political leadership that was "not blinded by the ideologies of the past " and their governments had "courage and the foresight" to drive reforms that sustained improved productivity and national competitiveness. [Argus] says the Hawke-Keating macro-economic reforms were underpinned by a sustained, relentless and exceedingly well informed micro-economic agenda. By implication, Argus is unhappy with the economic logic that drives the Rudd government.

Interview with Don Argus, retiring Chairman of BHP, The Australian 25/3/ 2010.

Financial Market recovery: It is helpful that the global financial system is gradually recovering its poise, after a near-death experience eighteen months ago. Perhaps like a patient that has suffered an acute cardiac event, there has been some lasting tissue damage, but quick intervention avoided something much worse. A period of emergency life-support has been, followed by a period of recuperation, with some ongoing medication, during which the patient has been able gradually to resume normal activities.

The Banking Sector: The challenges that remain ahead for the banking sector in major countries nonetheless remain considerable.

Challenges from Sovereign Debt: For several important countries there was a trend increase in debt-to-GDP ratios going on before the crisis occurred. It is these more deep-seated trends that are really the greater cause for concern. So a number of advanced industrial countries face some difficult fiscal decisions over the years ahead. Unless a credible path to fiscal sustainability can be set out, growth could easily be stunted by rising risk premia built into interest rates as markets worry about long-run solvency.

Economic Recovery: In the United States growth spurred by a swing in the inventory cycle is thought to have marked the turning point in the second half of 2009, but most observers still expect only moderate growth this year. In Europe, the momentum for recovery has been less certain. In important emerging countries like China, India, Brazil and a number of smaller east Asian countries the letter ‘V’ is a reasonable description of the the trajectory to date. (But) we should expect to see some moderation in the pace of growth of production in some of these cases this year.

Glenn Stevens, Governor Reserve Bank, 26/3/2010.

Credit and debt, in short, are among the essential building blocks of economic development, as vital to creating the wealth of nations as mining, manufacturing, or mobile telephone. Poverty, by contrast, is seldom directly attributable to the antics of rapacious finaciers. It often has more to do with the lack of financial institutions, with the absence of banks, not their presence.

Niall Ferguson, "The Ascent of Money", 2008.

 

WHAT IS THE RESERVE BANK GOVERNOR TRYING TO TELL US?

In our view the Governor is saying that we have not yet returned to normal in economic terms, in banking, debt, and growth terms. Australia may be in better shape than most, but we are still dependent on the global economy returning to ‘normal’ as soon as possible. The time table is unlikely to be calendar 2010 though by year-end things should be clearer. Oblique references to ‘some countries’ and ‘several important countries’ seem to refer to the USA and Britain, but protocol demands that inference is better than outing.

Yesterday the Governor also took the unprecedented step of giving a TV interview specifically to warn people about assuming interest rates will remain low as they accelerated their housing purchases.

Australia is dependent very much on growth in the world economy and interest rates are moving up in a pre-emptive move against (asset) inflation. The RBA is giving itself plenty of scope to halt rate rises, or even to ease, if world growth stutters.

 

WHY CAUSE FOR PAUSE?

In summary –

• China is trying to slow its economy.
• The USA is far from out of the woods and the printing press limits to prevent deflation are near to being exhausted.
• The trade and currency tango occurring between the USA and China.
• Australia is raising interest rates.
• Ecinya has a suspicion that the first half of calendar 2010 is far from robust and 2010 full-year earnings will be a subdued base for a number of companies .
• Forecasts for local 2011 earnings are generally high and will come under strenuous review once 30 June 2010 arrrives.
• The SP500 has hit an intermediate peak at 1174, some 68% off its March 2009 lows.
• The XAO is similarly 55% off its march lows.
• Momentum in both the US and Australian markets is slowing.
• Political uncertainty in Australia is rising with waste apparent in several government stimulus programs.
• First quarter US growth is a confusion with reputable pundits split below 2% and above 3.5%. Our suspicions veer to the lower end of the forecast range.

We have stressed patience over the past few weeks in "Ah Magoo, you’ve done it again" , "Patience: The hardest of the market disciplines" and "Watching, waiting, wary." However, you can observe that we have stayed fairly fully invested up until this week.

 

WHAT TO DO?

An ECINYA investment rule says: "Good trading is a peculiar balance between the conviction to follow your ideas and the flexibility to recognise when you have made a mistake. In a bull market focus on price & momentum, a bear market focus on valuation."

The stock-market is currently bullish, but in our view the market momentum is elevated enough to think about taking some profits plus the gap between perceived value and price has narrowed sufficiently to support such action. Accordingly, we have turned the Bamboo account entirely to cash after 14 weeks of operation, and created some cash in Cactus (see Ecinya Funds). However, there are still stocks where the valuation parameters are favourable and these stocks are contained within our Stock Recommendations. However, the market is, in our view, more of an ‘accumulate’ market than an outright ‘buy’.

Long range plans engender the dangerous belief that the future is under control. Try to stay flexible, open minded and sceptical. Good trading is a peculiar balance between the conviction to follow your ideas and the flexibility to recognise when you have made a mistake. In a bull market focus on price & momentum, in a bear market focus on valuation.

Ecinya Investment Rules 8 & 10, formulated July 1997.

Quincy Magoo is a cartoon character created at the UPA animation studio in 1949. Mr Magoo is a wealthy, short-sighted retiree, who frequently gets into sticky situations as a result of his near-sightedness, compounded by his stubborn refusal to admit the problem. People impacted by his various calamities tend to think he is a lunatic. After each triumph (calamity to others) Magoo exclaims "Ah Magoo, you’ve done it again!"

Edited extract from Wikipedia

Games played amongst even professional investors of Old Maid, Snap and Musical Chairs can be played with zest and enjoyment, though all of the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.

Thus professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not the case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipate what the average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

John Maynard Keynes circa 1936

 

OVERVIEW

Ms Magoo has joined the ranks of the Ecinya confidants, people we talk to on a regular basis who are market participants, aware of our views as we are aware of theirs. Since about 4 March Magoo and our editor have diverged on their market view. Magoo is fixated on levels of 5200 for the All Ordinaries and 1200 for the SP500 prior to a significant turning point occurring. Frustratingly for editor, Magoo has been correct in her assessment since the beginning of March. Under intense questioning, editor has asked Magoo "Why?" and Magoo throws a document at editor presented to her by editor some years ago, and says "Six prettiest girls!".

Editor is of the opinion that a tradeable turning point will occur before 5200 and 1200 and hopes to be over-weight cash at that time.

On 4 March we said; "In relation to the All Ordinaries index, the last downwave low was 4544 and as we go to press we are sitting at 4702, a mere 3.5% above the downwave low. The reporting season has been satisfactory, but not outstanding. In looking at 100 of the majors that have reported, about 28% have increased their interim dividend and a few companies have declined to give guidance. This suggests that though the worst may be over for most companies, caution is still a dominant theme. Also the interim report of Toll Holdings was a disappointment as Australia’s largest transport operator is suggestive of a sluggish economy. Though Australia avoided a technical recession in 2009 this had more to do with Australia’s robust financial position going into the ‘global financial crisis’ than management of the crisis once it came to pass. Summary: Our tactical position is ‘Going with the flow, without conviction’ and we are ‘comfortable’ and NOT ‘confident’, ‘bullish’, ‘very bullish’, and certainly not ‘euphoric’."

Editor has moved from ‘comfortable’ to ‘concerned’ as markets drift higher with the SP500 (our global proxy) and the All Ordinaries because the context does not feel at all conducive to further upside momentum at the moment and our position is fluctuating on an intra-week basis from ‘uncertain’, ‘relatively clueless’ to ‘comfortable’, to ‘concerned’.

WHAT ARE THE CONCERNS?

The markets have developed a speculative tone which is manifesting itself in two ways. Firstly, that a strong global economic recovery is surely happening. Fiscal 2011 forecasts are bullish; in our view, prematurely bullish. Secondly, local resource stocks, many in the ‘penny dreadful’ category, are rising indicating that people are looking for ‘easy’ profits. "Investment is not speculation" and to further emphasise the point we stress "speculation is not investment".

1) Strong global recovery: The economic stats are coming off such a low base that they are frequently said to be ‘exceeding expectations’. America is forecast to be providing 24% of total world growth for calendar 2010. But consider the following summary provided by James Quinn of quinnadvisors.com:

"Economic Factor	Peak to Trough So Far (as at 4 March 2010)
Real GDP Decrease	3.7% real decline from December 2007 until June 2009 totalling $500 billion
Personal Income	Personal income declined by $339 billion from mid-2008 to the 1st Qtr of 2009
Investment	Fixed investment has declined by $543 billion, or 24%, since December 2007
Unemployment	There are 8.1 million less people employed today than in 2007
Industrial Production	Has fallen 12% since 2007
Bankruptcies	National bankruptcies have risen from 800,000 in 2007 to 1.4 million in 2009, a 75% increase
Trade	Exports and imports declined by 22% and 31%, respectively, between July 2008 and June 2009
Currency	The USD has fallen 17% in the last year versus a basket of world currencies
Bank Failures	140 banks failed in 2009, with 700 banks in danger of failing, according to the FDIC"

 

In relation to bank failures some 26 banks have failed in Calendar 2010. Mr Quinn does not mention the fiscal difficulties being experienced by about 10 major US states, including California which on a stand-alone basis would be the world’s 6th largest economy. The Wall Street Journal Economics survey for March 2010 has 28% of their 57 economists with a GDP growth forecast for 2010 below 2.5%, and 9% below 2.0%. Consenus has moved since the February survey from 3.0% to 2.9%.

China is said to be in a speculative bubble involving mainly property speculation on the part of both investors and developers. There are many blog editorials on this subject. Doug Noland of Credit Bubble Bulletin encapsulates these views in the following transcripts –

China Bubble Watch:

March 17 – Bloomberg (Sophie Leung): "The World Bank indicated that China… should raise interest rates to help contain the risk of a property bubble and allow a stronger yuan to help damp inflation expectations. The nation’s ‘massive monetary stimulus’ risks triggering large asset-price increases, a housing bubble, and bad debts from the financing of local-government projects, the… World Bank said… The group raised its economic growth forecast for this year to 9.5% from 9% in January."

March 17 – Bloomberg (Bei Hu): "China is in the midst of ‘the greatest bubble in history,’ said James Rickards, former general counsel of hedge fund Long-Term Capital Management LP. The Chinese central bank’s balance sheet resembles that of a hedge fund buying dollars and short-selling the yuan, said Rickards, now the senior managing director for… Omnis Inc. ‘As I see it, it is the greatest bubble in history with the most massive misallocation of wealth,’ Rickards said…"

March 17 – Bloomberg (Jeremy van Loon): "China replaced the U.S. as the biggest investor in renewable energy for the first time in five years as the Asian nation raced to meet rising demand for power and reduce carbon emissions. China invested $34.5 billion in wind turbines, solar panels and other low-carbon energy technologies in 2009… The U.S. spent about half as much last year…"

 

CONCLUSION

Despite Ms Magoo’s pleasure in being ‘ahead of the curve’ and ahead of us, we are remaining sceptical in this market, adding to value positions, and taking short-term profits as they appear. However, based on the quant and technical aspects of the market, Magoo could be right for the month of March.

It is unlikely that God’s plan for the universe includes making you rich. Success in the stockmarket requires effort, discipline and patience. 90% of success is having the discipline to be consistent.

Ecinya Investment rule #1/ 10, July 1997

The task of a man is not to see what lies dimly in the distance, but to do what lies clearly at hand.

Thomas Carlyle, 1838.

Patience is a minor form of despair, disguised as a virtue. Patience is sometimes considered a virtue when it is merely a case of not knowing what to do.

20,000 quips & quotes edited by Evan Esar, 1968

A wise man seldom fails because he anticipates problems.

Feng Menglong

Domestic Economic Conditions: A significant amount of data had become available since the previous meeting ….Overall, these data had tended to be quite firm………Business surveys were generally showing that business conditions remained at fairly healthy levels. Surveys showed business confidence and hiring plans to be relatively high, but also suggested a degree of caution in many businesses’ investment plans. This was consistent with the recent ABS Capital Expenditure Survey, which suggested that investment outside of the mining sector was expected to remain relatively subdued.

Members noted that the contraction in business credit had slowed noticeably; the January data showed a decline of 0.1 per cent in the month, compared with declines of more than 1 per cent per month a few months earlier. Loan approvals had started to rise and the rate of repayments by firms was estimated to have begun to fall. More generally, banks were now reporting greater willingness to lend to businesses and there were fewer reports from firms of very tight credit conditions, while liaison indicated falls in risk margins paid by some borrowers.

The retail trade data had suggested relatively subdued sales in December but solid growth in January. Household surveys suggested that households were fairly confident overall about the future but (like businesses) were somewhat cautious in their views about spending.

The market for established housing had been very buoyant, with auction clearance rates at high levels, notably in Melbourne. Data for housing prices suggested that nationwide prices had continued to grow at a rate of close to 1 per cent per month in December and January. Building approvals in December and January were running at a relatively high level compared with the past year, but at a rate that was below the levels of previous peaks in home-building. Data for housing loan approvals had declined somewhat recently, consistent with what had occurred in previous episodes of monetary policy tightening. The recent falls were concentrated in approvals to owner-occupiers, with approvals to investors increasing, particularly in Victoria.

There had been no new data on consumer price inflation over the past month. However, the data for the wage price index for the December quarter indicated that growth in private-sector wages had remained quite low, while public-sector wage growth had remained firm. Overall, the staff still expected consumer price inflation to be around 2½ per cent over 2010.

Selected passages from the Minutes of The Reserve Bank of Australia dated 2/3/2010, released 16/3/2010.

 

ECINYA COMMENT

Two weeks ago we were of the opinion that March would be a good month to stay long and strong in equities. Then last week our technicals and quant data indicated that markets were hesitating and that an imminent retracement might be on the near-term horizon. Over the past fortnight news has surfaced that China may be in bubble territory, particularly relating to property speculation. The Shanghai composite index has retraced some 11% from December 2009 to date, and this provides some support to the emerging thesis that China growth may be slowing as the Chinese fiscal and monetary authorities focus on withdrawing stimulus from the economy. Trade and currency tensions are rising between China and the USA.

Locally, many of the people we speak to are wary of the sustainability of the recovery with some of the view that ‘it is not happening’.

Though ‘patience’ can easily be described as ‘not knowing what to do’ we are remaining cautious and have withdrawn funds from our portfolios, including Cactus.

 

OUR FUNDAMENTAL FEAR LIST FOR 2010 was contained in our Overview paper published on 12 January, 2010

We set out below those expressed fears in bold, followed by our current view:

America economic aggregates, and policy settings; negative trends in employment, current account and domestic deficits: The economic aggregates in America have worsened considerably over the past 3 months, with persistently high unemployment levels and rising public debt levels. Australia’s domestic deficit appears to be driving interest rates up and the stimulus package policies appear to have been substantially mis-managed.

The aftermath of American foreign policy history and its implications for global resource allocation and growth: The oil price has risen above US$80 per barrel and tensions between Israel, Iran and Palestine remain elevated. America appears to be losing patience with Israel.

The global economy and the possibility of growth rates disappointing as stimulus is withdrawn: This remains a real fear but official GDP numbers have not been revised down at this point in time. We remain sceptical and suspicious as Europe is slowing and the first quarter in the US appears to be sluggish. The Chinese Premier has warned of a double-dip global recession, led by American imbalances.

The lead into various elections around the world that might encourage profligate fiscal behaviour (UK, Australia, and US mid-terms are on the horizon): This is happening and is likely to accelerate as election dates are announced.

Higher global and local interest rates, particularly the latter, in context of rising inflation: Because ‘the global recovery’ is still in doubt, interest rates are likely to be subdued, though the Reserve Bank of Australia has acted pre-emptively and is ahead of the curve.

The unintended consequences of additional stimulation: Insulation batts and the schools building programme, centre-pieces of the last stimulation, are illustrative of this fear.

Another major institutional failure in the USA: Fannie and Freddie still under pressure, but no new notable failures in evidence.

A downgrade of US debt: Moodys have warned Britain and the USA that their AAA rating is in doubt, and probably under review.

China having a few problems which are currently overlooked such as slowing exports, failures in the small business sector, and non-performing bank loans: China fears are on the rise.

Rising taxation levels. In Australia this will be euphemistically called ‘tax reform’: The Henry Review has been withheld.

A break-out in local wages: Good news, not happening.

Unemployment staying persistently high: Real unemployment (adjusting for under-employed and casual workers) is still too high here and abroad.

Commercial property values globally: Commercial property is generally soft.

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): An additional 26 US banks have folded in calendar 2010.

 

THE RESERVE BANK MINUTES

A reading of the full transcript is recommended. Particular note should be taken of the qualifying adjectives and sentences e.g. ‘mixed’, ‘significantly’, ‘quite firm’,’ appeared’, ‘relatively’, ‘somewhat’ etc.

Go placidly amid the noise and haste, and remember what peace there may be in silence. Exercise caution in your business affairs; for the world is full of trickery. But let this not blind you to what virtue there is.

Max Ehrmann, ‘The Desiderata’, 1927.

 

Ecinya Comment

Over the past two weeks the market has not surprised us, but we have entered limbo-land waiting for the next move. It is easier to relate to our published portfolio (Cactus) to explain our mood and reflect on where we might be.

We are holding 50 stocks costing around $726,000 and currently worth around $683,000. These stocks have been funded by circa $466,000 of cash, realised gains of $246,000 and dividends and interest of $14,000. The Cactus Fund started on 6 January 2009 and progressed until March 2009 in a relatively passive way. Activity accelerated after 31 March, 2009. The returns have been very good and exceeded our benchmarks.

For the past 7 weeks Cactus has stood still with unrealised losses averaging about $41,000. All of these losses are contained in 7 stocks – Ceramic Fuel Cells, CMA Corporation, Primary Healthcare, Galaxy Resources, Clean Seas Tuna, CSR, and Redflex Holdings. Apart from Clean Seas we remain comfortable with these holdings whilst appreciating that ‘the market’ is disinterested.

Technically, the XAO enjoyed a 7.5% advance for the 51 days to 19 January 2010, folllowed by a 6.5% retracement for the 19 days to 15 February. The current XAO upwave is now 15 days old and the advance has been 5.4% or some 249 points, equivalent to an average of 36 basis points per day. This is all good, steady stuff.

Why then in limbo? We guess the answer lies in the fact that we cannot identify a catalyst that will dramatically drive the market higher in the short term, but a few things are possible. Firstly, we are about to enter the northern spring and economic activity in that hemispere traditionally picks up as the snow melts and the sunshine appears. Secondly, in Australia and elsewhere house prices seemed to have ceased their dramatic fall. Our local banking system is only wounded, but not broken, and lending is slowly on the mend… we emphasise slowly as banks seem to have A, B, and C class customers. The reporting season was, overall, satisfactory. So it all comes down to takeovers. That would give us a boost!

So we are watching, waiting, and wary.

 

Technical points of interest.

Our global proxy, SP500, reached an intermediate, post-crash high of 1150 on 19 January and XAO reached 4936 the day prior. SP500 is within 1% of that intermediate peak and XAO is within 2% of its intermediate peak. Keeping it simple, watch 1127 and 1115 on the SP500 and around 4725 on the XAO.

 

Context

Economic stats are getting better, but they are cum-stimulus and coming off low bases. Sustainability remains elusive.

 

Brevity

This is a brief article, well outside of our normal offering. Sometimes it is better to do nothing. Sometimes it is wise to remain silent.

The reaction to US foreshadowed stricter regulation of the financial world has caused reported falls in stocks across the board. This is an interesting reaction to a scenario that theoretically promises greater stability, less risk, less volatility and less room for manipulation than presently is available. I would be interested in Ecinya’s rationale as to why it considers the market is correct in falling when, to the layman, the promise of a more reliable less risky market place should make the market rise- or could it be as simple as the manipulators cashing in to go and play theft somewhere else?.

Brian Bolton, an Ecinya subscriber, 26/1/ 2010.

While I can understand the logic of your views on the Greek crisis, and the sovereign debt issues washing over the PIIGS, where are the solutions?

Prince Geoffrey, an Ecinya subscriber 22/2/ 2010.

There can be no respect for the truth without respect for the language. Only when language is alive does it have a chance. As the powerful in legend turn the weak or vanquished into stone, they turn us into stone through language. This is the essential function of a cliche, and of cant and jargon: to neutralise expression and ‘vanish memory’. They are dead words. They will not do for truth. When journalists ignore abuses of the public language by people of influence and power, and reproduce without comment words that are intended to deceive and manipulate. When this happens journalism ceases to be journalism and becomes a kind of propaganda; or a reflection of what Simone Weil called ‘the superb indifference that the powerful have for the weak’.

Don Watson in "Death Sentence: The Decay of Public Language", 2003.

Perceptions of the potentially distorting nature of large donations – either cash or other resources – to political parties will degrade the public’s trust in the integrity of the political process.

Senator John Faulkner 17/2/ 2010.

 

CONTEXT

The questions "Where are the markets going?" and "What happens next?" are obviously constants, and opinions are always divided. In fact it is a reasonable observation that when there is a substantial consensus it is liable to be wrong. In relation to ‘crises’, they can be real or imagined, and sometimes even convenient. The written word sets an opinion in stone, but the writer will change his mind as the data and/ or circumstances change. Also each person must interpret advice in context of his own positions and his own aspirations, and tolerance for risk. This is why we talk of ‘strategy’ and "tactics’ under our weekly Strategy tab and run a couple of portfolios using real money which attempts to impose some discipline upon ourselves.

Our current reading of the markets: Our global proxy, the SP500 is above 1100, closing last night at 1115. In the 19 day downwave which (on our calculations) finished on 15 February, the downwave low was 1057, about 6% below current levels. At the same time we are seeing some improvement in the US data that indicates that the USA will enter spring in better shape than the gloomy periods of Autumn and Winter of 2009/2010. Wherever the SP500 goes, any fall of 2% in a day or 3% in a week will be viewed with some concern. This translates into an SP500 level of 1092.

In relation to the All Ordinaries index, the last downwave low was 4544 and as we go to press we are sitting at 4702, a mere 3.5% above the downwave low. The reporting season has been satisfactory, but not outstanding. In looking at 100 of the majors that have reported, about 28% have increased their interim dividend and a few companies have declined to give guidance. This suggests that though the worst may be over for most companies, caution is still a dominant theme. Also the interim report of Toll Holdings was a disappointment and as Australia’s largest transport operator is suggestive of a sluggish economy. Though Australia avoided a technical recession in 2009 this had more to do with Australia’s robust financial position going into the ‘global financial crisis’ than management of the crisis once it came to pass.

Summary: Our tactical position is ‘Going with the flow, without conviction’ and we are ‘comfortable’ and NOT ‘confident’, ‘bullish’, ‘very bullish’, and certainly not ‘euphoric’.

An Interesting chart

This chart plots the course of the SP500 over successive up/down waves. It can be seen that the up-waves are getting weaker, indicating momentum loss, but the down-waves are of short duration and dimension from 2009

Our response to Mr Bolton

Markets work in the immediate past, the foreseeable future, and some commentators have a sense of history. Re-regulation of the markets will not automatically provide greater stability, less risk, less volatility, nor less room for manipulation. The markets always reflect the prevailing opinions and mood, and are never ‘correct’, in a strict sense. There is always a buyer and a seller, and one of them is right or wrong. There will always be mispricing and differing opinions of ‘value’. There was, and is, plenty of ‘regulation’ to control excesses, both accidental and fraudulent. Rather, the problem was to do with the inability of American regulators to recognise risk and in some cases to not act upon information and insights that clearly pointed out the risks involved in the American markets, and global markets generally (Madoff, IAG, sub-prime, General Motors).

The SP500 peaked at 1520 on 6 November, 2007 and the All Ordinaries peaked at 6853 on 1 November,2007, and are still 30% off their peak, though about 50% above their retracement lows. As early as 16 April, 2005 Paul Volcker in his full page article in The Washington Post – "An economy on thin ice" said: "Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks – call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What concerns me is that there seems to be so little willingness or capacity to do much about it."

That Mr Volcker, a doyen amongst practical economists and central bankers, was ignored for so long, indicates that the failings were of personnel, not regulation. And he was not alone then, or subsequently.

 

Our response to Prince Geoffrey

As a European, Prince Geoffrey sees a lot of the world on his frequent travels and in one of his university honorariums gets to speak with many academics and people involved in economics and the markets. The Prince cries out "Don’t tell me what I already know!" But, I respectfully point out that if we know so much and don’t act upon it, then what do we really know? (This is said with love and affection.) The Prince has been caught with his pants down on some occasions as he sticks to his well-worn thesis: "I am a long-term investor". So Prince, here are Ecinya’s solutions, specific to Australia:

• Australia should move to a 4 year Federal parliamentary term with a minimum period of 3 years. Ecinya is not in favour of fixed terms.
• Australia needs to get back on track with tax reform. We fear that the Henry Report will fail to address real tax reform and fail to impress us, you, and others.
• Donations to political parties should be abolished and a pool should be established to distribute donor cash – please see the Insights article Crony Capitalism: Capitalism’s Cancer. Crony Socialism: Socialism’s Endemic Malady
• The GST should apply to all goods and services, including food, and a raft of state and Federal taxes and charges should be abolished such as payroll tax, insurance taxes etc The Australian Treasury publication of August 2008 identified 125 different taxes imposed on Australian households and businesses.
• Capital gains tax should be ammended to define all capital gains as income and taxed on a sliding scale based on the time assets are held with nil taxation applying after say 7 to 9 years. Too many assets, particularly property, are being held in long-term hands because of the tax liability that would crystallise on sale. Capital velocity is important in a dynamic economy.
• The perennial, and mostly self-serving, debate about capitalism and socialism should be replaced by the expression ‘balanced free enterprise’. Peter Drucker often talked about the end of ‘capitalism’ and that it had, in fact, ceased to exist. He said on one interview occasion "Although I believe in the free market, I have serious reservations about capitalism. Any system that makes one value absolute is wrong. Basically, the question is not what are our rights, but what are our responsibilities." Balanced free enterprise would involve a defined role for government in the economy – say in good times government, expenditure should not exceed 20% of GDP; in bad times, it might float up to 25%.
• Companies should report annually every 3 months with a full year statutory report at the end of each 12 months. Continuous disclosure should be rigorously policed.
• Yellow cards should be issued to companies who transgress, obfuscate, engage in misleading or deceptive conduct. Three yellows and you get a red, and a visit from the corporate regulator follows. Myer, David Jones and Transpacific should have received yellow cards over the past few years, in our view.
• ASIC should be properly funded.

 

THE MARKET GENERALLY LEADS THE ECONOMIC RECOVERY

Investors can usually rely on the stock-market to foreshadow economic recovery and this particularly applies when the bust is cyclical in nature. This current bust has been somewhat structural in nature with massive failures in banking, oversight, fraud, and careless corporate behaviour. In relation to forward economic estimates about 60% of global growth of US$1.5 trillion for 2010 is forecast to come from just 3 countries, 30% from China, 24% from the USA, and 6% from India. American bank credit is limping and banks are reluctant to lend to the small business sector. In Australia a glance at the RBA statistics indicates that year on year residential mortgage borrowing are up about 10%, property investment borrowing are up about 4%, but business loans are down about 9%.

We continue to talk about the three economies- the real economy being the production of goods and services, the symbol economy – money and credit-, and the political economy. Clearly, the symbol economy is lagging the recovery and banks are reluctant to lend. Our concerns with the political economy are all to do with misallocation of resources and we are witnessing the insulation fiasco. Shortly, the school buildings programme will become a front page headline and this will dwarf the insulation debacle for waste. All government waste is paid for in higher interest rates and higher taxes.

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.

ECINYA 2010 Outlook, published 12/1/2010.

This is not a normal cyclical recession; this is a structural economic crisis. The United States is not a viable economy in its present form. Capitalism is being corrupted by government debt and paper money.

Richard Duncan, author of "The Corruption of Capitalism" on CNBC TV 23/2/2010.

America today has elements of all of the discredited ‘isms’ of yesterday hidden behind the facade of a supposedly free-enterprise economy and democratic system, though only about 26% of the population vote for any administration in office, and even less if the gerrymander is analysed in greater detail. The ‘isms’ are fascism, capitalism, social welfarism, big government conservatism, legalism, religious dogmatism, and powerful cronyism amidst pervasive elitism. The American elite has created national and international kaffirs, and within America itself second class citizens not encouraged to vote, who are as below the rule of law as the elite is above it. Success has bred excess: America has come to believe that its profligate behaviour in relation to energy consumption, poor wages in many areas of its economy, unfunded pension liabilities, a second class education system for many of its residents, the same in health; corporate welfare, tax shelters for those who can afford them, an excess of legal mantra over common sense and good sense, rampant debt creation largely involving other people’s savings, excessive speculation via derivatives and other exotic financial instruments, poor public and private accounting, has led to a country often seemingly out of control and exposed to regular crises, few of which are anticipated and after the event the response is shambolic.

ECINYA 2006 Outlook, published 13/1/2006.

The New York Times reported that one contract in 2001 involved Greece selling forward future lottery receipts and airport landing fees, for cash to write down debts. Josef Proll, the Austrian Finance Minister, said: "All the suspicions there are, suspicions of faked accounting…. must be cleared up. We’ll have to investigate."

The Times (London)16/2/2010

 

The 2010 YEAR AFTER JUST 8 WEEKS

We are comfortable with the Australian market, but less comfortable with overseas markets in Europe and America, particularly the latter. The latest reason given for market fragility is "the Greek debt crisis". For reasons outlined below we find this a difficult rationale, but the fact that it gets widespread acceptance as a valid reason indicates the fragility and volatility of the economic and market recoveries.

Our strategy is to sell the rallies, take a good proportion of our dividends, move from short-cash to longer cash. In our view not enough is happening in the global economy to convince us that a decisive move to the upside is in prospect. We are focused on stock selection and taking short-term profits to increase cash levels from time to time. Our guess is that markets will move within a range before slipping decisively mid -year and then staging a rally of reasonable significance towards year-end. Event risk is not priced in and we are viewing the Israel-Iran stand-off as potentially explosive.

 

TECHNICALLY

Our market focus in index terms revolves around the SP500 and the All Ordinaries (XAO). The nexus between the two is constant, almost irrefutable, and if there is a change in directional relationship it mostly involves currency. To 22 October 2009 the indices rose 25% over 74 days to 1092 SP500 and 4818 XAO; the retracement that followed lasted 9 days and the indices fell circa 5% to 1046/ 4547; next upwave was 8% over 51 days to 1150/ 4889; next down wave to 15 February 2010, 7% to 1075/ 4570. The current upwave is just 5 days old at +3% to 1108/ 4732.We are watching support around 1100 for the SP500 and anticipating resistance around 1120. In XAO terms we perceive support around 4700 and resistance around 4800. Remember our market is substantially cum dividend.

 

BUT WHAT OF THE PIIGS?

 

The PIIGS are Portugal, Ireland, Italy, Greece, and Spain. Collectively they account for around 35% of European GDP and about 6% of total global GDP. Though the numbers may be a little ‘rubbery’ we have created the Ecinya Triple Misery Index which is the aggregate of the unemployment rate, plus the percentage to GDP of the domestic deficit and the current account deficit. On an unweighted basis all of the PIIGS looks very miserable indeed. However, if we weight them on the basis of their share of global GDP the United States is the stand-out economy of concern. In this regard the quote above from Richard Duncan underscores how important it is that America gets its house in order and addresses some of the obvious imbalances that exist.

We need the American eagle to fly!

TIME IS NEEDED

There is a global recovery underway, but it will take time for confidence to return, for banks to start lending again, for companies to re-construct, for governments to get their balance sheets in order etc etc. The Bush-Blair global legacy is being unwound and residual damage has been done to Gordon Brown in the UK and the Obama focus on healthcare has raised questions about his administration’s interest in matters economic. Brown faces an election this year and Mr Obama has to get through the November mid-terms. Australia also has an election this year and many concerns are being raised about the apparent waste in the Australian stimulus packages.

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.

What then is this third economy? It is ‘the political economy’, an expression that has emerged over the past few months. The symbol economy and the political economy tails oft wag the real economy dog. Currently, governments are embracing very significant debt loads to prop spending up and unemployment down. Unemployed persons mostly become angry voters.

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.

 

 

 

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.

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).

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.

ECINYA Insights ‘2010: Our view of the year ahead’ 12/1/2010

  We are in day 19 of the current downward retracement. The All Ordinaries (XAO) has retraced 6.6% since the high of 4981 on 11/1/10 to Monday’s close of 4570. The S&P 500 (SP500) has declined 6.5% from the January high of 1148 on 14/1/10 to Friday’s close of 1075. It is little surprise that US trading was weak ahead of the public holiday on 15/2/10 (Presidents Day), so we will anticipate the coming day’s trade to see what the post-holiday sentiment will bring. Amidst talk of Greece defaulting on debt, the markets have hesitated, while volatility in the US dollar hasn’t helped clear a definitive path either. As John Mauldin states in his recent paper ‘If PIIGS could fly’: “Greece has in fact been in default in 105 of the last 200 years…[and Greece] stands at 875% debt-to-GDP when including off-balance sheet items!” If Greece were to default, the PIIGS’ debt concerns may not prove detrimental unless the topic of anxiety envelopes the US and Euro zone more generally. A shift in focus towards US debt levels, or increased talk or action taken on the country’s credit rating, would see a definitive move to the downside.  

XAO hit an intra-day low of 4508 on 5/2/10, keeping above that psychologically important 4500 mark. Staying above 4500 on XAO or 1050 on SP500 is crucial, as a dip below would initiate a more significant decline. Following such a move, support levels can be found at around 990 on SP500 and 4200 on XAO.

Despite a current sideways trend, technical analysis could argue that there is further downside to come. There is the possibility of a reversal in the Williams %R and RSI on SP500, and the XAO would follow, like a good puppy. In addition, the moving averages on both indices have crossed over on top of a clear downward sloping wedge. Piigs might fly?

This week we have republished the Insights article of Jan 27 “Early days of the anticipated correction”. As the market volatility increases, investors are uncertain. Or, as is eloquently stated in our strategy section: ‘A wide diversion between the Bulls and the Bears remain; rampant bulls on one side and negative zealots on the other.’ A review of this article, as well as the 2010 overview papers, may provide some perspective.

 

Early days of the anticipated correction

 

Think, Act, Review

Please re-read our most recent Insight Articles ‘2010: Our view of the year ahead’ and ‘Re-visiting last week’s 2010 overview’. Do not expect simple days ahead. Think, Act, Review.

THE CORRECTION HAS STARTED: Let’s look at the technical context first

The S&P 500 (SP500) reached 1148 on 14/1/10 and the All Ordinaries (XAO) reached 4981 on 11/1/10. These levels are 27% below the peaks of 1565 (SP500) and 6853 (XAO) reached on 9/10/07 and 1/11/07 respectively. They are 70% above the low of 676 (SP500) and 60% above the low of 3111 (XAO) reached on 9/3/09 and 6/3/09 respectively.

Give or take a day the primary trend from the lows is 223 days old (as at 27/01/10) and has proceeded as follows:

      First advance 43 days +25.6% XAO, + 37.4% SP500

      First retracement 5 days negative 4.1% XAO, negative 5.1% SP500

      Second advance 20 days, XAO +8.1%, +7.3% SP500

      Second retracement 20 days negative 6.7% XAO, negative 7.1% SP500

      Third advance 74 days +24.2% XAO, +27.1% SP500

      Third retracement 9 days negative 5.6% XAO, negative 4.2% SP500

      Fourth advance 52 days +7.7% XAO, +8.8% SP500

A few observations: If you are an Elliott Wave advocate you would probably ignore the first retracement, but we regard any fall greater than 2% over 2 consecutive days as a potential turning point and we observe momentum on a daily basis. It has been clear for some time that momentum was slow in the period of the fourth advance averaging just 26 basis points daily for the XAO and 38 basis points for the SP500, compared with the third advance when the numbers were 55 basis points daily XAO and 62 basis points daily for the SP500. Also note the harmonic relationship between the SP500 and the XAO. Why is this so? Simple… the USA is China’s largest trading partner and the world’s largest economy. China is our largest trading partner.

Momentum can also be viewed via the charts and we constantly refer to the Williams%R and the Relative Strength Indicator to signify over-bought positions. We use daily, weekly, and monthly measures in this regard.

How long will this correction last and what will be its dimensions? Our guess is that it will be relatively short as this is not the big one that we are expecting in calendar 2010. Looking at the fundamental context, we would put this view on hold if the SP500 moves above 1113, and the XAO moves above 4850. A bigger correction will be data driven, not the cacophony we are currently witnessing. Earnings in earnings-per-share terms is always the most critical data point

CONTEXT, FUNDAMENTAL VIEW

Using our Portfolio Menus, over the past 3 months our Buy/ Accumulate tally has averaged 20 stocks overall, a Buy/ Accumulate ratio of 13%. If the earnings season unfolds satisfactorily we expect this ratio to rise.

This 3-day old retracement is said to have been caused by two factors. Firstly, President Obama announcing that the banks have to now pay for their bail-out in some way- increased taxation, curbs on bonuses, and re-regulation. Secondly, that Ben Bernanke’s endorsement as Fed Chairman is now doubtful. In relation to the banks, their excesses have clearly been massive and these excesses have flowed from Wall Street to Mainstreet where massive unemployment, negative GDP, negative profit growth, and massive domestic deficits have resulted. It has been said of Wall Street :

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

And further:

We face two possible states of the world. One is a world in which our economic problems are largely solved, profits are on the mend, and things will soon be back to normal, except for a lot of unemployed people whose fate is, let’s face it, of no concern to Wall Street. The other is a world that has enjoyed a brief intermission prior to a terrific second act in which an even larger share of credit losses will be taken, and in which the range of policy choices will be more restricted because we’ve already issued more government liabilities than a banana republic, and will steeply debase our currency if we do it again. It is not at all clear that the recent data have removed any uncertainty as to which world we are in.

John Hussman, Hussman Funds Management, December 2009. (From ECINYA Insights 8/12/2009.)

The Wall Street banks would not be regarded as ‘banks’ in Australia. The vaporised names – Merrill Lynch, Bear Stearns, Lehman – were speculative trading houses in commodities, derivatives, collatorised debt obligations, hedge funds, and private equity buy-outs. The still-standing major names – Goldman Sachs, CitiBank, UBS, Morgan Stanley – appear to have learned little from the economic chaos of 2008.

In Ohio last week president Obama said; "We want some rules in place so that when you financial guys make bad decisions, we don’t have to foot the bill. That’s pretty straight-forward." Warren Buffett has suggested confiscation of CEO’s assets and their wives’ assets as well. This is pretty serious stuff and transcends debates about capitalism vs socialism, and neo-cons etc. On 12 December Ecinya said: "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."

In relation to Ben Bernanke we note that he has received a ringing endorsement from Mr Greenspan. That, of itself, should cause serious questions to be asked and serious reservations to surface. America’s last central banker of substance was Paul Volcker.  Just ask him who should be Chairman of the Fed.