Ecinya

“Each year, the world demands more and more energy, with no end point in sight. And each year, it is more and more evident that the extraordinary machine we have built to supply that demand cannot sustain itself in present form. Not a day goes by without some new disclosure, some new bit of headline evidence that our brilliant energy success comes at great cost – air pollution and toxic waste sites, blackouts and price spikes, fraud and corruption, and even war. The industrial-strength confidence that was a by-product of our global energy economy for most of the twentieth century has slowly been replaced by anxiety.”

The end of oil: on the edge of a perilous new world, Paul Roberts

 

“It’s a lack of leadership. It’s a lack of being able to take on the oil industry and the automobile industry, and recognising that they’re not Uncle Sam.  Uncle Sam has to be Uncle Sam, and Uncle Sam is acting like General Motors.”

S. David Freeman, Energy Adviser (Carter Administration)

 

“And here we have a serious problem: America is addicted to oil.”

George Bush, State of the Union address, 2006

 

“Every country must have an industrial base. The only way you can do that is by building new industries of great value that make a difference in the world, and that can provide better jobs. I think that’s a very necessary social resolve for what we’re doing, and that’s why we say we are changing the world for the better.”

Stanford R Ovshinsky, Developer of EV1 battery, Co-founder of Cleantech Group and Founder of Ovinshky Innovation

 

 ECINYA COMMENT

We’ve all heard of the Toyota Prius or the Honda Insight – trendy hybrid cars that not only save the planet and your pocket, but have seen the likes of Cameron Diaz and Jack Nicholson swap their Italiano sports cars to step out on the red carpet from a green vehicle. BMW and Mercedes shortly followed suit to ensure they didn’t miss out on market share.

Less talk and celebrity-fuelled publicity has arisen about the electric car, a vehicle that is even more environmentally friendly and energy efficient, requires less maintenance, operates quietly and smoothly, and, in fact, was first introduced in the 20^th century. Despite its advantages, the electric vehicle (EV) was drowned out by its competitor, the petrol car, due to mass production and cheaper oil. The EV has its drawbacks; the battery packs do not last the distance that petrol cars do and take longer to recharge than the 5 minutes it takes to fill up a petrol tank. These pitfalls are being investigated further by scientists in order to produce a car that can meet consumers’ expectations, the biggest inconvenience being the ability to go the distance. Mass produced EV’s are not available in Australia but this may change in 2010-11. Currently, a top-performing EV costs $130,000-$150,000, shipped from the US, with a waiting period of about 2 years. Alternatively it is possible to convert your current petrol vehicle to an EV for approximately $15,000. Unfortunately, no government rebate is available for this conversion.

If these operational disadvantages are overcome, however, will we see an increase in EV owners? The average consumer may bear a heightened awareness of climate change and fuel cost efficiencies, but it is unlikely that the ‘powers that be’ will welcome such a dramatic shift of economic dependence. One of the greatest advantages of an increasing market in EV’s is a decreasing dependence on foreign oil. The energy source is domestically produced (even if the electricity is sourced from coal powered plants, the environmental impact is drastically reduced), but fuel companies obviously have a strong incentive to deter growing independence from oil.

Oil has played king of commodities, economies and policies. Over the past week, Dubai has announced that it is struggling with debt repayments, yet global market anxiety has eased and there is an expectation that Abu Dhabi will come to its neighbour’s aid if worse comes to worst. The oil sheikhs will step in and save the day. Saudi Arabia has about one fifth of the world’s oil reserves and is the biggest crude oil producer. We have seen oil sky-rocket to just under $140 in June last year, before trading in its current range ~45% below this high. The commodity has a lucrative earning potential. However, oil can only remain profitable if alternative fuels are not a viable option.

Furthermore ex-heavy weights from the energy and motor corporations have been in top positions in the White House, such as Condoleezza Rice, who was also a director of Chevron Corporation. California toyed with the idea of an electric car mandate, pushing for an increase in zero emission vehicles, and this, along with a push for mass-produced electric vehicles, has been swept under the carpet.

LPG fuelled vehicles have gained interest, emitting lower emissions than petrol or diesel engines. Australia has a large supply of gas from Bass Strait, offering less reliance on the Middle East. Bass Strait LPG is also a major export earner to countries including China. Rebates on the intallation of LPG to existing petrol & diesel engined vehicles and for new vehicles fitted with LPG are available from the Australian Government as a "green" incentive.

The International Energy Agency, OECD, predicts that by 2030 Petroleum Fuels will account for 80% of worldwide fuel usage; Biofuels will account for 12%; Electricity 6%; and Natural Gas 2%. OPEC’s forecasts are similar in nature as there are no major assumptions concerning future shifts in demand for oil. India is the biggest importer of oil and developing countries’ need for the fuel only points towards an increasing demand. However, the automobile industry is the largest consumer of oil and alternative vehicles can weaken dependence and addiction. Thus the electric car has the potential to transform the global economy, affecting trade not only in oil, but in steel, chemicals and nonferrous metals as well as electricity generation and distribution.

Additionally, Sherry Boschert, author of Plug-in Hybrids: The Cars That Will Recharge America, conducted studies demonstrating that the use of EV’s would reduce carbon dioxide (CO2) emissions by 0-59% when compared to petrol cars, even if using electricity produced by coal. If the electricity were to be produced by solar or wind power, emissions would be completely eliminated. Yet as the debate over emissions and their potential impact upon the environment and the economy reaches boiling point, politicians are entangled in a power struggle, whilst Australia’s consideration of the EV remains deficient.

In Denmark the government has agreed to remove its 180% tax on EV’s and Israel will reduce tax from 72% to 10% on zero-emission vehicles. Tax incentives help accelerate the adoption of EV’s and Nissan Motor Co. Chief Executive, Carlos Ghosn, believes that high fuel prices will further spur demand for alternative-energy fuelled cars in coming years. Therefore could government support of EV’s become a viable alternative to an emissions trading scheme (ETS) as an attempt at fighting climate change? An investment in such an industry, poised to become the way of the future, is as yet virtually non-existent in Australia. Such an undertaking makes more sense than the $43 billion national broadband network, the largest single investment in infrastructure in Australia’s history, for which no cost-benefit analysis was undertaken.

The development of an EV industry would no doubt come with its own set of difficulties and criticisms, but the environmental benefits would be undeniable and job creation a positive outcome. Moreover a key component of many electric cars is the lithium-ion battery and in the 2009 US Geological Survey Australia was listed amongst the world’s top six lithium producers, with approximately 23% of the world’s broad base lithium reserves, suggesting the opportunity for growth in exports should the EV market continue to grow worldwide.

Thus, this ‘little’ car should not be ignored. More than just a quiet ride, it has potential benefits for the environment and economy worldwide. Keep an eye on it.

By Nicole Loewensohn and Emily Stewart

We’re enjoying sluggish times, and not enjoying them very much…….. The year ended with the concern for Americans that are hurting, because of this sluggish economy. I mean, when families are having trouble making ends meet or are thinking, even if they have a job, I might not have one tomorrow. Fear. You worry about that. I worry a lot about that.

George Bush snr, 1992

The propensity of Congress to create benefits for constituents without specifying the means by which they are to be funded has led to deficit spending in every fiscal year since 1970, with the exception of the surpluses of 1998 to 2001 generated by the stock-market boom. The shifting of real resources required to perform such functions has imparted a bias toward inflation. In the political arena, the pressure to make low-interest-rate credit generally available and to use fiscal measures to boost employment and avoid the unpleasantness of downward adjustments in nominal wages and prices has become nearly impossible to resist. The American people have tolerated the inflation bias as an acceptable cost of the modern welfare state.

Alan Greenspan, "The Age of Turbulence", September 2007.

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 foreknowledge of only one economic variable, the one you would choose would be 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.

Ian Macfarlane, former Governor of The Reserve Bank, 14 June 2005.

 

ECINYA COMMENT

All governments talk of lower taxes, lower interest rates, higher spending on more and more pervasive benefits for the disadvantaged, incentives for the corporate sector if they also happen to be benefactors at election time, and spending on ‘nation building’. The fact that governments have no money of substance other than what they raise from taxes or borrow, one would think that expenditures would be thoughtful, careful and have a reasonable set of priorities. Alas, that is hardly ever the case, with Peter Walsh and early Howard regarded as notable exceptions.

So we are left with the central bankers to provide the checks and balances through monetary policy, to apply some brakes to the natural political inclination to be profligate and wasteful. In America this has not worked for some considerable period because Mr Greenspan became part of the political system. But in Australia it has worked. Hence, when we are talking about the sustainability of ‘the recovery’, we must rely on the good intentions and thoughtful policies of The Reserve Bank.

We find it interesting that Mr Greenspan talks of the ‘welfare state’ and America is still having a debate about ‘capitalism’. It sometimes seems that there is more free enterprise in Communist China than in Capitalist America… funny hah, hah! Just think about the bail-outs of the US auto and banking industries; not that they were unnecessary but the scale and enthusiasm was almost grandiose.

Once upon a time, business leaders used to speak up against bad policy – people like the Chairman of The Stock Exchange and senior bankers. But they are now so fearful of subtle forms of ‘punishment’ that no longer happens. It is left to the press to be the investigators that reveal bad, sometimes reckless, fiscal behaviour.

Our tax system needs reform, but will it occur? There will be some changes promoted as ‘reform’, but the main ingredients are likely to be confused and confusing. On top of the ’emissions trading scheme’ confusion, we may enter a period of multiple confusions. The GST should be imposed on food; payroll taxes removed; capital taxes relaxed to reward longer-term holders and encourage capital velocity; pensioners, teachers, nurses, and policemen should be paid more.

BUT if the world economy continues to move from emergency relief to recovery, Mr Macfarlane says we will be all right, and we agree with him. Therefore, we need to be continually alert to what is happening in the world economy. In general terms we are looking for a negative year of circa 1% GDP growth for calendar 2009, followed by 3.0% for 2010 and 3.5% for 2011. Trend is about 3%, which means that world GDP doubles about every 24 years.

THE STOCKMARKETS

In order to assess levels and direction for the Australian stock-markets our primary focus is on the S&P 500 and the All Ordinaries index. The latter is currently contained in a range 4500 to 4800 and the former in the range 1075 to 1110. Our expectation is that a correction will occur soon that takes our market to around 4400 and the S&P to around 975. This equates to an 8% correction for the All Ordinaries and about 13% for the S&P 500. Volatility might be, at times, uncomfortable.

As we drift towards the end of 2009 we need to understand that the drift is in context of an Australian market 50% above its lows in March of this year, but still 30% below its peak in November 2007. The corresponding numbers for the S&P 500 are 30% below the peak and 60% above the March lows.

Why ‘drift’? Volumes are low and muted, and the momentum of the advance is declining. Also, at the time of new Ecinya’s first publication our buy-accumulate-spec buy ratio as a percentage of our total stock universe was 39% and it is now running at about 19%.

FEAR AND THE WISDOM OF TWO BUSH PRESIDENCIES THAT INHERITED STRONG ECONOMIES AND BEQUEATHED RECESSIONS

Much comfort can be found in the wisdom of George Bush snr, a kindly, well intentioned man, but something of an economic illiterate, just like his son. We advise everyone to read the Bush quotes over-and-over again, and then stoutly ignore them, remembering that government is hardly ever the friend of the honest taxpayer-worker. Simply exercise caution in your own affairs, because Messrs Obama and Rudd, though articulate to varying degrees, seem to be playing the economic game of ‘the free lunch’. Each seems to be more of a celebrity than a manager.

We think Mr Obama will change, we sense that Mr Rudd cannot escape his predilection for spin over substance and mischievous and clever wedge politics. If we had longer Federal parliamentary terms, the perception that spin is valuable might change to some degree. Suffice it to say, Ecinya has more faith in the substance of the Australian people than its current crop of politicians.

Mr Obama needs to change direction in 2010 and become something of an economic pragmatist, now that the emergency has passed. Mr Rudd will have to be forced by an election set-back in early 2010 to regain his self-confessed, conservative credentials and hope that external conditions can make Australia continue to look good. In our prayers we should all mention China and India. America has a long way to go and Europe just limps along, aided by the tourist dollar.

ECINYA’S SURVEY

In January 2009 we asked 8 of our confidants to join our editor (making 9 in all) to write down their five major fears/ worries for 2009. This gave us 45 responses (9 times 5).The table below summarises the results:

Responses

• US in all aspects, $US, Obama… 10……………………………………………………….22%
• Australian government policies & abilities… 8………………………………………..18%
• Deflation – recession deepens, asset values continue decline… 6………. 13%
• Geo-political – oil price, middle east, wars etc… 4…………………………………… 9%
• Wages and employment… 3……………………………………………………………………. 7%
• Banks willing to lend, bigger bank losses… 3………………………………………….7%
• Confidence – market, DIY super losses… 2……………………………………………. 4%
• Public & private debt levels… 2……………………………………………………………….. 4%
• Drugs, alcohol, law & order… 2……………………………………………………………….. 4%
• Australian management… 1……………………………………………………………………. 2%
• China over-saves… 1………………………………………………………………………………. 2%
• Trade wars… 1……………………………………………………………………………………….. .2%
• Energy policies globally… 1……………………………………………………………………. .2%
• Resources bust… 1………………………………………………………………………………… 2%
• X factors… 1…………………………………………………………………………………………….. 2%

We found the second most dominant fear to be interesting and consonant with our own generalised fears. The Hawke-Keating government were sound economic managers, before turning into micro-populists, mainly instigated by Mr Hawke in his final term. The Howard-Costello government were sound economic managers before turning into micro-populists, mainly instigated by Mr Howard in his final term. Transition is just as important in government as it is in business, and poorly orchestrated leadership changes are costly for taxpayers.

SO WHERE ARE WE NOW?

David Rosenberg gives the following summation of the American condition:

• Short-term negative interest rates in the bond market with people more concerned with capital safety than yield
• Housing crisis far from over
• Dose of near-term caution for the commodity sector; though remaining long-term bullish
• Some yellow flags over the holiday retail sales season
• Lots of hesitation in capex as excess capacity remains high
• No sign that the recession is "really over"

The US economy has been hopelessly managed since Ronald Reagan said "It’s always morning in America", except for a period where the abrasive Newt Gingrich controlled the economic debate through a Republican controlled Congress. However, things can change and as John Maynard Keynes (everyone’s favourite dead prophet) said "Fundamental change does not occur quickly".

AND IN AUSTRALIA

Our major worries are : The tax system, a flawed approach to carbon emissions, a poor prime minister and treasurer in economic terms. Even Peter Walsh recently described Mr Rudd as an ‘economic illiterate’. Additionally, we are also watching China with a more than usual degree of care.

Go placidly amidst the haste and noise remembering what peace there may be in silence.

The Desiderata, Max Ehrmann, 1927

Chaos is not dangerous until it begins to look orderly. A hunch can be trusted if it can be explained. It is unlikely that god’s plan for the universe includes making you rich. Optimism means expecting the best, but confidence means knowing how you will handle the worst; never make a move if you are merely optimistic.

Extracts from The Zurich Axioms by Max Gunther, circa 1980

The good news is that we have not fallen off into another Great Depression. With the degree of stimulus there seemed little chance of that, and we have consistently expected a global economic recovery by late this year or early next year. The operating ratio for industrial production reached its lowest level in decades. It should bounce back and, if it moves up from 68 to 80 over three to five years, will provide a good kicker to that part of the economy. Inventories, I believe, will also recover. In short, the normal tendency of an economy to recover is nearly irresistible and needs coordinated incompetence to offset it – like the 1930 Smoot-Hawley Tariff Act, which helped to precipitate a global trade war. But this does not mean that everything is fine longer term. It still seems a safe bet that seven lean years await us.

Jeremy Grantham, a distinguished US Fund Manager, October 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. Pretty soon there is a boom.

Bill Bonner writing on fiat money, 2007

Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to pick up. Conditions in financial markets were roughly unchanged, on balance, over the intermeeting period. Activity in the housing sector has increased over recent months. Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability. With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

US Federal Reserve statement 4/11/2009

 

ECINYA COMMENTARY

From 19 October 2007 to 9 March 2009 the All Ordinaries index and the S&P 500 (our global proxy) were in a primary downtrend for 355 days of 55% and 57% respectively. From 9 March 2009 the primary uptrend has lasted 178 days and the All Ordinaries is up 51%, and the S&P 500 is up 59%. Our Insights column of November 3 was written against the background of an S&P level of 1042 and XAO of 4546. As of last night these numbers are 1108 and 4773, a ‘bounce’ of 6% and a ‘bounce’ of 5%. Our expectation, and our hope, back in early November was that the markets would fall by about 8-15% which in our generalised view would have the indices more in line with our fundamental perspective.

From those levels, the economic and earnings fundamentals could re-assert themselves and an orderly market advance would follow with a focus on sustainable economic, earnings-per-share, and dividend growth. Balance sheets would have been restored from new share issues and the earnings recovery.

But it now seems to us that the global stimulus has barely impacted the real economy – the production of goods and services – and instead flowed in abundance into the symbol economy – money and credit. Bankers, the architects of the ‘great recession’, are back in bonus and it seems that a government debt bubble, in guise of nation-building without analysis, is manifesting itself. Politicians, central bankers, the IMF all in charge of sustainability and stability, were asleep at the wheel. These same institutions with little semblance of change are now meeting in various places to pronounce a new era of global co-operation abroad, amid ‘co-ordinated’ stimulus at home. The choirs are singing from the same hymn book. Only Mrs Merkel seems to embody a sense of truth and responsibility. The rest are today’s heroes, saving our women and children from the burning building that they set alight in the first place.

The fact that we are likely to emerge triumphant from ‘the great recession’ is not currently in doubt……. but our hunch is that the markets are too far ahead of that emerging recovery. We want a ticket at the game, but we don’t want to pay too much to participate in the applause.

It is Tuesday about noon, and last night in the US our global proxy rose to 1108. CNBC TV said that this was due to ‘better than expected, indeed strong, retail sales’. We looked at our daily US market site, Nasdaq.com, and the commentary said ‘retail sales data for October comes in a bit mixed, while business inventories for September decline less than expected’. With these statements seemingly in conflict, we visited DismalScientist where the data is set out in great detail and discovered that retail sales month-on-month rose 1.4%, but if you exclude autos then they rose 0.2%. Further, if you go into the year-on-year numbers, retail sales fell 2.6%. Knowing that our stockmarket is dominated by US brokers and that there is a 2 day nexus between New York and the XAO, sometimes leading by a day and sometimes lagging by a day, we were disturbed on Monday our time that our market was strong in the afternoon. This strength was vindicated by the overnight strength in the US. But today, our market is lacklustre and yesterday turnovers were exceptionally light. We are uncomfortable.

Additionally, on a more macro and longer-term perspective we are finding our modelled assumptions are not throwing up a large number of buying opportunities and so our conclusion is that about 80% of our stock universe is effectively on hold. In February/ March 2009 the position was largely reversed with about 60% of our stock universe on ‘buy’. When we first published the new ECINYA pages on 28 July 2009, 39% of our stock universe was on buy/accumulate/spec buy. Today that number is 18%.

STRATEGY

Our strategy is to be over-weight cash; about 30% in investment-accumulate mode, 43% in special situations, and about 12% in speculative stocks and 15% in cash.

TACTICS

Going with or against the flow, with or without conviction, comprises the 4 pillars of our tactical positioning. The fifth pillar is ‘Ambivalent, uncertain, relatively clueless’. This is where we are today, at this moment.

LOOKING TO OUR QUOTES ABOVE

The Zurich Axioms are just old-fashioned cynicism, but contain significant truths.

We are not as pessimistic as Jeremy Grantham about his home country, America, but we can understand his relative pessimism, and his caution.

Bill Bonner reminds us that central bankers (and fiscally reckless parliaments) can create illusions of wealth and economic activity.

Ben Bernanke is part of the Greenspan-Rudd school of double-speak and speaks and behaves like a politician. In his defence, perhaps, he cannot tell us the truth, simply because as Jack Nicholson said in the movie " A Few Good Men’, "We can’t handle the truth!!"

SO

Our hunch is to avoid chasing the obvious momentum and wait for better, and more sustainable, official and anecdotal data to emerge. Beating low expectations is hardly progress. As Peter Ustinov once said: "I love the guy who aims low and misses."

BUT AUSTRALIA

…… is in relatively good shape because the Howard-Costello fiscal legacy has given us deep pockets and our central bankers are independent and are raising interest rates. Additionally, we have the China story to under-pin our economy and that appears to be relatively sustainable.

‘Argument’: A discussion in which reasons are put forward.

Collins Dictionary

There is nothing so beneficial as an argument between persons of goodwill.

Old Jewish proverb, source unknown

‘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. Speculation is not investment. Know when you are merely engaged in speculative activities.

Ecinya Investment rule #2/ 10, July 1997

The information you have is not the information you want. The information you want is not the information you need. The information you need is not the information you can obtain. The information you can obtain costs more than you want to pay.

"Against the Gods: The Remarkable Story of Risk" Peter L Bernstein, 1996

In preparing for battle I have always found that plans are useless, but planning is indispensable.

Dwight D Eisenhower, circa 1942

 

A subscriber comment/ question from Mr Bolton 3/11/2009:

‘Do you anticipate producing detailed info on companies along the lines ETrade used to or revealing a little about the logic behind your modelling?’

 

Editor’s initial response 4/11/2009:

‘Dear Brian

 Having known you for some years now and enjoyed your capacity for meaningful dialogue and earnest debate your question requires a lengthy answer. You probably knew that, but need to maintain your reputation for mischievous behaviour. Next week’s insight issue will be devoted to our answer which should be of benefit to you, other readers, and ourselves.

 But a quick response is still warranted. ‘Do you anticipate producing detailed info along the E*Trade lines’….. the answer is yes, but not until we move into our new city premises early next year. Never forget though that Huntley’s Your Money Weekly has good coy info and nearly every company has a web-site you can easily access. Our real value is our recommendations on market direction, and when, and at what price to buy stocks. Sell decisions are mainly up to you. We really just say every week the amount we are prepared to pay for a stock. We will initiate a sell reco only if we think the stock is well over-priced/ over valued.

 BUT we will reveal a lot of the logic behind our modelling in our response to you next week, but not in so much detail that we give away our proprietary ‘secrets’. A bit like a Scotsman you have to imagine (or analyse) to a certain extent what may be under the kilt.’

 

The Bolton Response

ECINYA operates on multiple levels and these may be referred to in familiar terms of ‘top down’ and ‘bottom up’. However, it is essential that they meet in the middle as a formulated and structured basis for action. The market is so dynamic that our convictions, though firm, are changed by new information, challenged by new questions, and thwarted or rewarded by subsequent events -nearly all of which are outside our control and influence. All we are in charge of, really, is ourselves. The process of Think, Act, Review springs from our deliberations.

In the About Ecinya section we say: ‘ECINYA is an acronym for Exercise Caution In Your Affairs and is meant to remind both you, and us, that in order to get rich quickly you should endeavour to get rich slowly, as all endeavours require appropriate management of risk, and time. The stock-market from time to time appears to be an easy endeavour, but neither the economic cycle or market cycle is dead, and profits won on one adventure can disappear in the next. Folly can easily follow triumph. Those that tell you the market is easy, ‘either do not know, or do not know that they do not know’ (J K Galbraith).

Ultimately, success in the stock-market comes down to you, for no matter how much we know, the future is difficult to predict, both in relation to time and dimension. No one cares as much about your money as you do and Ecinya encourages you to develop sources that can assist you to take advantage of many sources of information. In looking at source material be mindful of confirmations and divergences of opinion. The aim of the Ecinya pages is to help you to build a set of thought processes to assist you to successfully invest, and occasionally trade. It is considered that occasional trading can enhance performance.

In defining the Ecinya approach, which is almost exclusively fundamental, our proximate matrix is 35% fundamental company, 25% the global economy, 20% the national economy, 13% technical analysis, and 7% quantitative analysis.’

 

OUR PRICING/ VALUATION MODELS

The Ecinya valuation models operate at both a macro and micro level. The macro involves a view on current and future interest rates, confidence, and the current stock-market. The macro inputs apply to our entire stock universe. At the micro level we have a rating matrix for operational and corporate credibility, excess growth potential, x-factors and gearing levels. The sum of the macro and micro gives us a ‘fair value price-earnings-ratio’ for each stock. We determine the EPS from Aegis Equities Research, consensus numbers, our view of company guidance, Huntleys, and our own formulated view on the company’s earnings profile. We DO NOT rate management, and instead assume that management is self-serving, engaged in self delusion, obfuscation, or outright lies. Over many years our editor has met just one trustworthy company that does not spin, or engage in market and self-deception. We read many annual reports, stock-market announcements etc. We have a wide range of confidants who have views on a wide range of industries. Our models give us a target price 6 months hence, 12 months hence and 18 months hence. Essentially, our models are really all about the macro and micro mathematics.

 

WATCH THE LANGUAGE

Language is important in corporate communications. So much of it is truly dreadful, and in such quantity we can only believe it is aimed at encouraging you not to read any of it. We are especially wary of euphemistic expressions like ‘robust’, ‘solid’, ‘challenging’, ‘values’, ‘governance’, ‘key performance indicators’, ‘benchmarks’ , ‘stakeholders’, etc. We are cognisant and a devotee of the ideas of Don Watson expressed in his book ‘Death Sentence: The Decay of Public Language.’ We do not like annual reports obviously written by public relations ‘experts’. Recently, we were greatly amused by the theme of the Transpacific annual report ‘365 days of progress’ following a year in which the company had to restructure, dilute shareholders, and experience a share price fall from about $10 to near $1. Also watching David Jones run full-page ads about how they were a better investment than Myer pre-float, without even mentioning their track record on EPS growth, was truly disappointing. How did responsible directors approve of such rubbish? We believe that David Jones should have received a warning from ASIC on the content of these ads. Also the Myer prospectus seemed to imply that Jenifer Hawkins was a good reason to buy shares in their over-priced float.

 

GLOBAL and LOCAL ECONOMICS

We read books, we subscribe to various web-sites and magazines. The Dismal Scientist is an expansive and expensive web-site that provides global data on a daily basis. We build macro-economic models from these sources, looking for trend and absolutes. Data is hardly ever meaningful until you have accumulated a lot of it and attempted to make the macro data fit with the market cycle and the micro stock views. The fit is never easy, but the data analysis causes you to determine confirmation or divergence. Timing is always the problem. In relation to the national economy we generally pay particular attention to ANZ Economics and Westpac Economics as we have timely access to their publications and have developed a view as to the reliability of their conclusions.

 

TECHNICAL ANALYSIS

We always look at a chart and have developed a set of principles around which we can analyse and interpret charts. Charts are described by Carl Swenlin as "a wind-sock, not a crystal ball". Our interpretive principles involve measures like moving averages, price channels, bollinger bands, trend lines, support and resistance levels, momentum etc. What we are looking for is confirmation, or divergence, from our calculated fundamentals. If our model says a stock should be going up and it is going down, it is generally clear that the market is either mistaken, or knows something we do not know. Can we find the question? Can we find the answer? The market is not always right; there are frequent divergences between price and value. We also consult with a gifted chartist whom we call ‘Compass’ and we seek his views on a regular and on-going basis. We read various chartist web-sites, mainly in relation to our global proxy, the S&P 500, as well as charts on commodities and currencies.

 

QUANTITATIVE ANALYSIS

One of our former employees developed a model built around the principles enunciated in publications by Victor Sperandeo. This was originally called the SM model, but our editor added some bells and whistles and it is now called the SMS model. It is updated daily and calculates a daily forecast on the All Ordinaries and S&P 500 indices. Inputs plus algorithms generate an answer. We describe the results as giving us confirmation, divergence, or extreme divergence. It is then up to the market to agree or disagree with the extrapolated results.

 

ICE

ICE is a simple acronym for interest rates, confidence, and earnings. Having a view on each is a handy guide to formulating our views.

 

STRATEGY

Our strategy is to be long the market and to switch between stocks and cash. We do not like the expression long-term, believing that the long-term is the result of the accumulated short-term (less than six months) and the medium-term (less than 18 months). The Ecinya Market Barometer is our short-term view reduced to a simple picture and is available on the web-site. We break our stocks into 3 broad categories: Investment Accumulate, which is about 60% of our total portfolio positions; Situations, which is about 30%; and Speculative, about 10%. In relation to Speculative this would include small and mid-cap oil stocks, gold stocks, commodity stocks other than majors, takeover targets, recoveries such as Elders, a bio-tech stock such as Bionomics, or Clean Seas Tuna. We are accumulating modest positions in a few lithium stocks at present that are very speculative, but there is an underlying story. We try to avoid ‘tips’, but are always interested in ideas and concepts.

Our Portfolio Menus under the Stock Recommendations tab segments our 135+ recommendations into Core Investments, Core Potential, Major Cyclicals and Situations, Resources, Secondary Cyclicals and Situations, Small Caps (under $250m), and Speculative.

 

TACTICS

Our tactical stance determines the shares/ cash mix. It is covered under the Strategy tab each week and comprises five tactical positions: (1) Going with the flow, with conviction, (2) Going with the flow without conviction, (3) Going against the flow with conviction, (4) Going against the flow without conviction, (5) Ambivalent, uncertain, relatively clueless.

 

IDEAS/ CONCEPTS

…..spring from discussion. Sir Alex Cairncross, talking about ‘ideas’ and John Maynard Keynes said: "I remember particularly a lecture in 1933 when he tried to convey how new ideas were born. Never did they arrive, he said, with the hard edges that later critics came to attribute to them when trying to define their terms. Ideas were apt to be like fluffy balls of wool with no fixed outline and the relationship between concepts when first perceived was likely to be equally wooly." Keynes mistrusted intellectual rigour of the Ricardian type as likely to get in the way of original thinking and saw that it was not uncommon to hit on a valid conclusion before finding a logical path to it.

 

OUR CONFIDANTS

An exchange of views between long-term colleagues is always useful. Our confidants are frequently mentioned in the Ecinya pages: DOG (the Duke of Glenorie) a macro-derivatives trader and expert on the Middle East, SOT (the Sage of Toukley) a long-term investor and short-term trader with specialist knowledge on commodities, the Delphic Oracle – a Greek fund manager of some fervour, Compass the chartist and market participant, Vector a quant analyst… There are others. We share insights, debate direction and quiz one another on fundamentals.

 

POLITICS

Much of modern economics centres around the role of government and the action, inaction, and misguided and occasionally successful outcomes of politicians. We like stability, quiet achievement, low taxes, sound fiscal policy, and sounder monetary policy from an independent central bank.

Paul Krugman in ‘The Great Unravelling’ 2003 said: "To talk about economics requires, more and more, that one write about politics."

Governments fight wars with taxpayers’ money, social inequality, and build commercial infrastructure, institutions, fly people to the moon and back, educate our children etc. All of this is understandable but there is a real problem when the private sector is squeezed by government excess, and the ‘invisible hand’ of private enterprise and innovation is stifled. Once government gets beyond about 22% of the economy we are generally troubled.

 

THE DESIDERATA

Exercise Caution IN Your Affairs (ECINYA) is an acronym derived from The Desiderata, which was written by Max Ehrmann in 1927. It is in our foundation document and has been for about the past 30 years. As is everything else that we can think of, it is available via Google.

 

No Doubt

…..Mr Bolton will be relatively satisfied with our response, but we are expecting more questions over time. We thank him most sincerely for his interest and the role he has already played in the evolution of the ECINYA pages. He has made us think; in turn, we hope we have made him think.

Our editor and The Sage of Toukley (‘the Sot’) have frequent conversations about the direction and pace of market expansion and contraction, always in a jocular and constructive context, but with occasional differences in emphasis and sometimes, significant disagreement. In fact, it sometimes is disturbing to each of us when we reach a point of unequivocal agreement. It is reasonable to say that we have discussed ‘turning points’ on many occasions over the past few years, obviously against the background of four years of excess returns. One only falls from dizzy heights. If ‘it’s too good to be true’, it often is, as investors in Westpoint and Fincorp have recently discovered.

We, Sot and editor, do agree that the world has dramatically changed in an economic sense over the past two decades, and more especially over the last decade. A lot of this, Sot and editor put down to growth in education (especially in the emerging nations), and communications, plus the end of the natural and historical advantages enjoyed by the United States of America during the bulk of the post World War ll period. Knowledge, ability and achievement of results are more widely dispersed than ever.

Our caveat though is that Sot and editor are never complacent and the debates will continue. At a fundamental level we grew up as realists and optimists and this endemic condition remains unchanged.

Ecinya’s ‘When Rooster Sot begins to crow, be careful’ issue published on the E*Trade web-site on 13/4/2007.

THE MARKETS’ ENDLESS DANCE: Economic recoveries are a waltz, and the market since the March lows has been doing the tango, the cha cha cha, and in some cases, rock and roll. Our models are suggesting that most stocks are at or near fair value and that forward earnings forecasts do not suggest a significant advance from here. Once forecasts are boosted by a more robust macro-economic picture of enduring quality, the market will have good reason to continue its advance.

Ecinya Insight 25/8/2009.

THIS is a ‘made in America’ global recession. IT IS NOT POSSIBLE for the Obama administration to have so quickly solved the problems that have caused the ‘global financial crisis’….. the GFC. All that the Keynesian response has done is to have ‘plugged the holes’. The ship is still full of water, and making its way towards the safe-haven of the shore where coconuts and fresh water are in abundance. The G20 account for 80% of world GDP and Australia accounts for 1% of world GDP. It seems that the US markets are already pricing in 4% GDP for calendar 2010 according to some economic and market commentators. America is about 20% of global GDP and for the world economy to function at, or near, a ‘normal’ level, America has to be functioning at or near its potential. ‘Potential’ is about 3% GDP growth per annum. America has not yet faced up to its systemic and structural problems, though they have begun to be addressed.

Ecinya Insight 15/9/2009

Straws and camels, questions searching for answers: Sometimes analysis is simply a question searching for an answer. Sometimes we are just looking for the straw that might break the camel’s back. After a day off to celebrate Labour Day in New South Wales, the ACT and South Australia, we began the day with a high level of uncertainty and had moved to our number 5 tactical position of ‘ambivalent, uncertain, relatively clueless’. (The other four tactical positions are outlined under the Strategy tab.) What brought this on?

Anyway, to clear his head our editor went for a walk to the bank and to buy some lunch. This caused him to think about the up-coming Myer float, which he considered to be considerably over-priced. Tactically, up until recent weeks, we stayed on the bus. We have just hopped off and decided to wait for the next bus. For us, the straw that has broken the camel’s back has been the pricing of the up-coming Myer float at between 14.3 and 17.3 times earnings when we think a reasonable multiple might be around 12 times. Based on median earnings per share of 27.8 cents, the vendors are targeting a share price/ value of $3.90 to $4.90. Our rough calculation puts us at about $3.35. But perhaps yesterday has arrived again today and perhaps the old Jewish proverb "Ecinya, you are my friend. I would not advise you to buy what I am selling" does not apply today.

Ecinya Insight 6/10/2009

JUMPING OFF THE BUS, BUT STILL AT THE BUS STOP WAITING FOR THE NEXT BUS TO COME ALONG: We have just moved to 25% cash across our portfolios including our published portfolio ‘Cactus’ where our cash balance stands at 32%. Good trading and investment is a peculiar balance between the conviction to follow your ideas and the flexibility to recognise when you have made a mistake. The problem with today’s markets, vis those of the nostalgic past, is that markets have many more participants, are more globalised, often driven by computer programs, entry and exit costs are cheaper than ever, there is an excess of bad behaviour including rampant spin from gifted professional pundits and the companies themselves. Additionally, the ASX, once it became a public company became less robust in policing bad behaviour and ASIC is always behind the curve as it is under-funded and its personnel under-trained and lacking in experience. This all adds up to one word …..’volatility’. We have long believed that a trading mentality must accompany an investment mentality if you wish to out-perform the general indices.

Ecinya Insight 20/10/2009.

IS RECOVERY CALLING?

In short, we believe the answer is ‘yes’. But the caveat is ‘what sort of a recovery?’ Our guess/ extrapolation/ forecast is that the recovery express will be somewhat volatile and uneven this side of Christmas with Christmas itself likely to be relatively subdued for most retailers and this naturally flows back into the banking, production and distribution sectors. The strength of the $A will assist profitability for local retailers as most of the stuff they sell is imported, but discounted sales will be rife. The question that we need to address is momentum (the rate of advance) of the recovery and sustainability of the recovery.

In looking at the recovery through the prism of the market our position for some time has been that the market had got ahead of the fundamentals, that speculation had returned, and that earnings uncertainty was high. None of this has changed.

Post Christmas our guess/ extrapolation/ forecast is that the question of sustainability will become clearer. To assist with the analysis, a re-visit to George Soros’ "The New Paradigm for Financial Markets: The Credit Crisis of 2008 and what it means" might assist.

 

GEORGE SOROS

……..said : "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 II 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."

"The Bush administration shows no understanding of the predicament in which it finds itself. Eventually, the US government will have to use taxpayer’s money to arrest the decline in house prices. Until it does, the decline will be self-reinforcing, with people walking away from homes in which they have negative equity and more and more financial institutions becoming insolvent. The Bush administration resists using taxpayer’s money because of its market fundamentalist ideology and its reluctance to yield power to Congress. It 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."

 

LEADERSHIP

Sot reminded editor just this morning that "leadership should not be under-estimated when coming out of an economic crisis". Sot reminded editor of the basket case economy inherited by Geoff Kennett when he became Premier of Victoria in October 1992, following 8 years of Labor government under John Cain and 2 years under Joan Kirner.

There is little doubt that America has swung to the left under the Obama-Reid-Pelosi led Democrats with an expressed belief that more government is better than less. Harking back to March 2005 following our editor’s visit to China, the following recollection was published as part of his series "The China Diaries":

"As our editor walked back down the steps of the Hall of Central Harmony in The Forbidden City, he noticed an immaculately dressed and handsome African American reading the information board he himself had read some minutes before. Editor addressed the man: ‘Do you think George Bush would understand that?’ He replied in a wonderfully resonant voice : ‘No way man, that boy wouldn’t even come close.’ We both chuckled and moved on to the next palace. The board read:

"The Way of Heaven is profound and mysterious and the way of mankind is difficult. Only if we make a profound and unified plan to follow the doctrines of the centre, can we rule the country well."

This was a proclamation of Emperor Qianlong of the Qing Dynasty made in 1645."

Australia’s fortunes depend principally on the strength of the world economy, though we can make things better or worse by inappropriate policy. America is about 20% of the global economy and this has a flow-on impact to Asia in particular, and the world in general. Will the Obama administration return to the centre? That is the question. We are hopeful, but not yet confident and that fits neatly into the theme enunciated by Soros above.

America is not yet united behind Obama. Significant sections of the Republican party still cling to the myth that Ronald Reagan (1981 to 1989) was a competent economic manager. His administration was saved by Paul Volcker in an economic sense and America endured significant pain as hyper-inflation was brought under control. Also, Ronald’s devotees believe that he won the cold war and discount the role played by Gorbachev. It was the Reagan administration that spawned Cheney and Rumsfeld, regarded by many as substantially incompetent across a wide range of geo-political and economic landscapes. It has always been a point of some interest that both of the George Bush presidencies, father and son, inherited an economy in very sound shape and managed to exit their presidencies leaving behind a recession of some significance.

Obama has a to-do list that is awesome and covers: Iraq, Afghanistan, Pakistan, peak oil and climate change, Wall Street villains, an unprecedented budget deficit, healthcare and an aging population, a malaise in manufacturing and an intractable current account deficit, tax reform, protectionism and free trade debates. Resolution of all or some of these questions also fits neatly into the Soros theme above.

It is about the 1 year anniversary of Obama’s election win and next January will be the first anniversary of his Presidential reign. Ecinya will be looking for changes that will begin to properly address the systemic and structural problems that accelerated under Reagan more than 28 years ago. Unity will be important.

 

SO WHERE TO NOW IN MARKET TERMS?

Fundamantally the market is generally fairly fully priced. Technically we expect that 1012 and 4400 in S&P and All Ordinaries index terms should hold our market. If the S&P bounces from the evolving current 7 day down-wave and bounces above 1061 then the down-wave is questionable, and may be over. If 1012 is broken on the S&P then 992, 972, and 952 comes into focus and levels in the All Ordinaries below 4300 are possible. But at this stage we are not expecting such downside. The markets are still being manipulated and dominated by hedge funds and Wall Street villians that have migrated to the developed and emerging world. Transparency is not transparent as yet, but it will need much more than regulation to achieve properly functioning markets. Exercise caution in your affairs.

Inflation is always and everywhere a monetary phenomenon.

Milton Friedman, 1968.

‘Inflation’: A disproportionately large and relatively sudden increase in the general price level. Inflation may occur when the quantity of money or deposit currency in circulation is large compared with the quantity of goods and services offered, or when, because of a loss of confidence in the national money on the part of the public, a general and widespread attempt to convert money into commodities is precipitated. A normal increase in the price level after a period of deflation is generally not regarded as inflation.

‘Deflation’: A decrease in the general price level. Deflation may occur when the quantity of money or deposit currency in circulation is small compared with the quantity of goods and services offered, or when the fear of failure or some other cause curtails consumer spending materially, thus reducing the velocity of circulation.

‘Reflation’: Inflation or deflation of the currency in order to restore a former price level.

‘Disinflation’: A term recently coined to indicate a planned reduction in the general price level, so administered that the economy is benefited by increased purchasing power and not harmed by drastic deflation.

Sloan and Zurcher’s Dictionary of Economics, 1961 – cost twenty-two shillings and sixpence (decimal currency arrived in 1963). We wonder what this book would sell for in today’s inflated dollars. When purchased, our editor’s weekly wage as a junior accountant and part-time university student was 17 pounds.

Outsourcing of interest rate policy is an epic experiment whose longevity remains uncertain. Politicians do not usually surrender power. This surrender was based on two ideas: A recognition that central bank management might lead to a longer growth cycle; and a calculation that letting the Bank, not governments, determine interest rates might work in the long-run favour of politicians.

Paul Kelly "The March of Patriots, the Struggle for Modern Australia", October 2009.

As long as governments control money supply there will always be booms and busts. I became almost cynical as I watched an avowed gold standard and laissez-fair advocate, Alan Greenspan, take the chairmanship of the Federal Reserve Board and turn into an expert at saying nothing with far too many words – the hallmark of every ‘good’ politician.

Victor Sperandeo’s, "Trader Vic – Methods of a Wall Street Master", 1991.

 

ECINYA OVERVIEW

One of our readers asked us to write a piece on inflation and though we have commented sporadically on this topic over the past decade, we have never devoted an entire article to it. We thank Neddie Seagoon for his interest and contribution.

A bit of inflation is a good thing as it denotes a restoration or continuation of price stability. Note here that price does not equate with value, divergences occur for all manner of reasons. One of the central premises of economics is that demand and supply determine prices. Shortages generally mean higher prices and excess supply generally means lower prices. Always the major caveat is government interference in the market place that can cause supply distortions, demand distortions, and even price distortions.

In relation to the price of labour – wages – we can have mandated minimum wages, taxes on wages such as compulsory superannuation (a good thing) and payroll tax (a bad thing), an increase in unemployment benefits leading to a greater demand to become unemployed, immigration leading to an increase in the supply of labour, education leading to an increase in the quality and vocational diversity of labour etc etc. Mr Dixon of Qantas has recently demonstrated that a timid, benign and short-sighted board of directors can mandate unreasonable remuneration. How fortunate have we been that Allco did not succeed in their takeover aspirations, so warmly recommended by the then Chief Executive and his then Chairperson.

Our conclusions:

• Some inflation is better than none.
• In an era of excess capacity it is difficult to see inflation as a problem, but trade embargoes or other impediments can qualify this conclusion.
• Deflation is awful and words and happenings like recession, slow-down, and depression appear to be sinister sisters or belligerent brothers.
• Growth, recovery, are congenial companions to measured inflation.
• Inflation needs to be managed and probably a target of 1-2% is appropriate in an at-trend-growth economy.
• Growth above 3% is near enough to trend for Australia and most developed economies.
• Inflation needs to be always looked at in context, and such matters as education, tax policy, and employment policies do matter.
• Governments cause more inflation than do most central bankers.
• Our Federal election cycle is too short, leading to misallocation of resources and poor policy formulation and execution.
• Always trust falling interest rates to begin a new bull-market.
• A lot of official figures on inflation and other macro variables are ‘rubbery’ and comparison between countries is often biased in favour of the position being argued.

 

THE THREE FACES OF INFLATION

…. are an increase in the price of goods and services, an increase in asset prices, and the trade deficit impact on the current account deficit. Goods and services inflation is mainly expressed via the consumer price index, where a basket of goods and services is used to monitor changes in the inflation rate.

Asset price inflation applies to assets such as equities and housing. The trade deficit relates to the fact that importing a good or service can be perceived, or actually be, cheaper than producing the same good or service locally. Ecinya believes that not enough attention is focused on import replacement because exports are ‘sexier’ and manufacturing would require some robust economic decisions.

Just today we have been informed that meat and vegetable prices are falling because of the current appreciation in the $A . SOT, an Ecinya confidant (as is Neddie), often points out that there is rich man’s inflation and poor man’s inflation. SOT is so wealthy that things like international air-fares and classy restaurants bother him. He recently took advantage of a cheap flight to the UK because he could buy one ticket and get one free. Relative frugality has enabled Sot to prosper. As an example of his frugality and patriotism, he has always driven a General Motors vehicle and spurned the imported toys of BMW, Mercedes, Rolls etc although his wife recently purchased a Mercedes sports car, but our guess is this was to allow Sot to play golf in England and Scotland on his recent overseas adventure. We mention these things because the easy way to avoid inflation is to buy cheaper, or not buy at all, or spend your holidays overseas on a relative-value basis. So that in many ways, inflation is something of a choice.

Similarly, with house purchases: Houses are more expensive often due to location such as near the sea or in a highly regarded suburb. Fashionable housing in the Southern Highlands was selling at a premium, until recently. But even affordable housing is made more expensive by taxes such as the GST, stamp duties, and delays in construction due to the council approval process. Also, governments influence the availability of housing via re-zoning changes. The cost of living away from a workplace adds another dimension to goods and services inflation with higher travel costs. As populations increase, road infrastructure has to be paid for from higher traffic fines and other forms of taxation such as road taxes on transport vehicles and even income taxes. An inflationary increase in the price/ value of housing does not automatically add to either more housing or more wealth. More often than not, it just adds to the cost of housing as mortgage rates increase or slow-down the housing price appreciation. Given that housing is generally a major asset, house prices impact markedly on consumer and voter psyche. Those with low, or no, mortgage houses feel advantaged. Those with high mortgage housing, or no house at all, feel disadvantaged.

In relation to the trade deficit the obvious examples are Japan in the 60’s and 70’s where low-quality exports were replaced by high-quality exports as their skill levels and product development skills improved and America gave up its desire to manufacture. We all know the story of Honda, Toyota, Panasonic, Sony, Seiko, Mizuno, etc. In the 90s China has replaced a lot of our local manufacturing in basic household items such as ironing boards, kettles, TV screens, clothing, stationery, books, glassware, furniture, mobile phones, computers etc. A job lost in Australia is often a job created in China, or elsewhere. In looking at the deflationary impact of cheap imports we do not seem to analyse the reduced consumption levels at home, the taxes paid by manufacturers, and the compensation paid to unemployed workers. Additionally, certain social costs often derive from a pool of unemployed workers such as drug dealing, gambling and crime. Yesterday the Japanese-owned tyre manufacturer, Bridgestone, which has received 20 years of government support, closed down in Adelaide and 600 jobs have been lost. Bridgestone produced a quality tyre, and no doubt its viability has been impacted by imports.

 

THE ECONOMY THAT WE LIVE AND WORK IN

….is not the inflation adjusted economy.

Real Gross Domestic Product (GDP) is nominal GDP reduced by the inflation rate. Nominal GDP is the world we inhabit and is the source of profits and wages, and after unavoidable costs, of disposable income. Disposable income drives our consumption and our savings. Aggregate savings are used to drive investment. Savings can be public or private. Australia over recent years has had a domestic surplus which has facilitated infrastructure spend and reduced personal tax rates and helped keep interest rates at appropriate levels.

 

CENTRAL BANKERS AND INFLATION

Saul Eslake, ex-ANZ, and now with the Grattan Institute, published a paper titled "Inappropriately low interest rates are as dangerous as inappropriately high ones" in The Age newspaper on 17 September 2009. In part, he said:

"The global financial crisis had many causes, but among the more important of them was that the US Federal Reserve under Alan Greenspan, and his counterparts at central banks in other major advanced economies, kept interest rates too low for too long in the aftermath of the mild recessions which followed the collapse of the internet bubble at the beginning of the present decade."

"The mistake was not in cutting official interest rates to what were, at the time, unprecedented lows after the ‘tech wreck’ and the terrorist attacks of 11 September 2001. Rather, the mistake was in keeping interest rates at the levels struck in response to those events until as late as November 2003 in Britain, August 2004 in the United States and December 2005 in the Euro zone, long after the requirement for unusually low interest rates (to counter the risks of recession and deflation) had passed. Keeping interest rates too low for too long had two important consequences which came together in such devastating fashion in the global financial crisis."

"First, the extended period of inappropriately low interest rates enticed many American households, whose incomes or previous credit histories would ordinarily have precluded them from becoming home owners, to take out mortgages which they were subsequently unable to service once interest rates eventually began returning to more normal levels. This consequence of abnormally low interest rates was, to be sure, compounded by the way in which sub-prime mortgages were constructed (with artificially low ‘honeymoon’ rates and capitalization of deferred interest payments), but sub-prime mortgages would never have caught on in the way that they did had the general level of interest rates not been so low for so long.
More generally, the extended period of unusually low interest rates also encouraged those who had previously been able to access mortgage finance to take on more debt than would have been possible otherwise, adding to the upward pressure on house prices from those newly enfranchised in the housing market."

"Second, the extended period of unusually low interest rates encouraged investors to take on more risk in order to obtain rates of return that could no longer be provided by relatively low-risk investments. This ‘ferocious search for yield’, as Adair Turner, Chair of the UK Financial Services Authority has described it, prompted a response from the ‘supply side’ of the financial services sector in the form of an ever-growing range of increasingly risky investment products cater to the growing demand for them – products whose risk characteristics neither their creators nor regulators fully comprehended."

"In short, the choices made by central banks in the US and other major advanced economies to keep short-term interest rates too low for too long encouraged both an increased demand for risky investment products and a greater supply of them. One of the reasons (although, again, not the only one) why Australia’s experience of the financial crisis has been less severe than that of most other Western countries is that Australia’s central bank was one of the very few that didn’t make the mistake of leaving interest rates too low for too long in the early years of this decade."

We cannot say it any better than Saul. We do, however, mention that Greenspan’s interest rate policy resulting in (fraudulent) prosperity at home, psychologically mitigated concerns about wars in Iraq and Afghanistan, and the high price of imported crude oil.

 

GOVERNMENTS AND CENTRAL BANKERS

Australia is relatively blessed in that our central bankers in discharging their obligations to assist the attainment and/ or maintenance of stable prices, balanced and sustainable growth, are independent of government. However, the Head of Treasury, currently Ken Henry, sits on the RBA board and has an input to the decision-making process. It was rather remarkable that the Treasurer, Wayne Swan, has been reported as saying, in parliament, that "fiscal policy has nothing to do with monetary policy". Yet, we know that the overall stimulus package has been increased government spending and borrowings, cash injections from the RBA, and lower (even down to ’emergency’ levels) interest rates.

Ian Macfarlane, ex Governor of the RBA, wrote an excellent book "The Search for Stability", which is exceptionally readable and available in paperback.

The nation’s top two economic advisers, Glenn Stevens and Ken Henry, yesterday warned the public to prepare for a series of short and long-term sacrifices as the economy returns to normal, with interest rates to rise rapidly and tax reform to leave some people worse off.

Front page The Australian 16/10/2009 by George Megalogenis.

Business hit as dismissal claims soar: Unfair dismissal applications almost doubled in the first few months of the Rudd government’s new work-place relations regime, prompting business to warn the rise will drive up costs and create a disincentive to hiring new staff.

Treasurer Wayne Swan hit back at coalition accusations that his spending pressured the Reserve Bank to raise interest rates, declaring yesterday that interest rate rises had nothing to do with fiscal policy.

Pgs 1, 7 of The Australian Financial Review 20/10/2009.

Australia didn’t have a financial crisis. The US did. No bank failed in Australia. No bank needed capital. No bank needed to be nationalised. No bank even made a loss. You ought to assess the fiscal stimulus that’s been undertaken against the mid-year forecasts. What they will show is that the Treasury over-estimated the economic downturn. What was undertaken was low-quality spend – $900 cheques that are now all gone and what have we to show for it?

Peter Costello’s last press briefing upon his parliamentary exit, The Australian 20/10/2009.

Politics is a story of conflict. In Australia, it is the Labor-Liberal conflict. For the media, conflict is the story that counts. For history, however, national progress is measured by the opposite test – where Labor and Liberal agree. Such agreement, rarely a story, is the foundation of all national progress. Australia rose phoenix-like from the ashes of the early 1990s recession to enter a low inflation growth cycle of such robust resilience that it became the longest economic expansion in the nation’s history. In the fifteen years to 2007, real income per head rose more than 40 per cent and real wealth per head more than doubled. This shifted the nation’s political culture towards markets, aspiration and enterprise while it generated an anxiety that Australia was losing its egalitarianism and social conscience.

Paul Kelly "The March of Patriots, the struggle for modern Australia" October 2009.

Is the United States bankrupt? Many would scoff at this notion. Others would argue that financial implosion is just around the corner. This paper explores these views from both partial and general equilibrium perspectives. It concludes that countries can go broke, that the United States is going broke, that remaining open to foreign investment can help stave off bankruptcy, but that radical reform of US financial institutions is essential to securing the nation’s economic future. The paper offers three policies to eliminate the nation’s fiscal gap and avert bankruptcy: a retail sales tax, personalized social security, and a globally budgeted universal healthcare system.

Introduction to Professor Laurence J Kotlikoff’s essay in The Federal Reserve Bank of St Louis Review July/ August 2006.

 

JUMPING OFF THE BUS, BUT STILL AT THE BUS STOP WAITING FOR THE NEXT BUS TO COME ALONG

We have just moved to 25% cash across our portfolios including our published portfolio ‘Cactus’ where our cash balance stands at 32%. Good trading and investment is a peculiar balance between the conviction to follow your ideas and the flexibility to recognise when you have made a mistake. The problem with today’s markets, vis those of the nostalgic past, is that markets have many more participants, are more globalised, often driven by computer programs, entry and exit costs are cheaper than ever, there is an excess of bad behaviour including rampant spin from gifted professional pundits and the companies themselves. Additionally, the ASX once it became a public company became less robust in policing bad behaviour and ASIC is always behind the curve as it is under-funded and its personnel under-trained and lacking in experience, this all adds up to one word …..’volatility’. We have long believed that a trading mentality must accompany an investment mentality if you wish to out-perform the general indices.

Having called the March rally and jumped on the bus with a measure of gusto (though we ignored most of the banks for nearly all of the time), we now find ourselves in the position where we simply do not know what is going on. So: time to pause, reflect, get off the bus, sit on the sidelines, have a breather, wait for earnings and the economy to catch up with the market. "When too many people are doing the same thing the market will adjust. Buy when others are despondently selling. Sell when others are greedily buying". Markets do not go up forever and the current bounce, in our view, has had the potential to tire for most of the past 8 weeks. But it hasn’t as the FOMO factor came into play …. fear of missing out. So we have tired ahead of the market but with technical indicators partially, or potentially, confirming our view.

Additionally, we are not enjoying the macro. The policy failings of the current government and the opposition response of attacking the man rather than the policy means that taxpayers and consumers are ill-prepared and ill-informed. Also, the American macro is unsound and that’s still the world’s largest economy, despite rapidly retreating from its dominance.

Now we may be wrong, but we feel that we must follow our view, for good or ill. We may be premature. We may be absolutely wrong. Keynes (a kindred spirit communicating from the grave with Messrs Rudd, the US Congress, Geithner, Pelosi, and Obama) said "Markets can stay irrational longer than you can stay solvent." At this moment we are so excessively solvent that our excess of conservatism may be a problem. Time will tell. Anyway, we can always jump back on the bus as we still can afford a ticket.

 

PETER WALSH

…..was the Finance Minister in the Hawke/Keating government and wrote an excellent book "Confessions of a Failed Finance Minister" in 1995. He retired in 1993 and has only occasionally ventured into print since then. Writing in the AFR on 10/12/2003 he said: "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."

Where is the bad policy – industrial relations, the stimulus package poorly targeted and badly implemented, the cash hand-outs – wasteful and extravagant, the proposed broadband network, the ETS scheme which will be a shambles and achieve little to nothing, and the rhetorical attacks on the ‘neo conservatives’, whatever that means. Sure George Bush was hopeless and John Howard got too close to Mr Bush’s view of the world, but Mr Rudd is indicating that he already is what John Howard became, without ever having been what John Howard was.

Q: What was Howard? A: A competent manager of the economy? Q: What did John Howard become? A: A reformer who lost the feel and the zeal, and instead wanted to be popular.

Mr Rudd is not showing any signs of being a competent economic manager and our debt loads are large and likely to get worse before they get better and possibly the debt reduction plan (the ‘exit’ strategy) will be conceived and implemented as badly as the ‘input’ strategy, the stimulus. An excessive government share of GDP squeezes out the private sector, particularly at the small business end – the dominant and sustaining employer group. Mr Rudd is taking wedge politics to a level of sophistication that is dangerously short-sighted and economically damaging.

Mr Swan says that fiscal policy has nothing to do with monetary policy and vice versa. He is indicating that he is an economic illiterate. A dopey Treasurer. But to show some fairness we should say that Mr Hockey is far from credible endorsement on the fiscal front and his platitudes on interest rates, jobs etc are confusing and confused.

Apart from ‘crisis’, ‘revolution’, and ‘fair’, our editor is not receptive to the word ‘tough’. Bob Hawke, Paul Keating, Peter Walsh, and John Howard steered Australia to its current position with some considerable assistance from John Stone of Treasury and Ian Macfarlane of the RBA. We have to be careful of regression under the current parliamentary team. But though the persons named provided steerage, the ship of prosperity has always been the Australian people. Subject to a properly constructed and pragmatic welfare system "No man is great enough, or wise enough, for any of us to surrender our destiny to. The only way in which anyone can lead us is to restore to us the belief in our own ability to take responsibility for our own lives." (source unknown)

 

STIMULUS, STIMULI, AND MISLEADING AND DECEPTIVE CONDUCT

We avoided a technical recession, so what? Our national debt was zero and the Liberal party and other pundits said it was going to $300 billion, encouraged by Messrs Rudd and Swan. It now looks like ‘only’ going to $200 billion. Mr Swan wants to be congratulated because he has saved us $100 billion. Jolly good. Exaggerate the recession, call it a ‘CRISIS’ ad nauseum, and then exaggerate your role. Sounds and looks more like ‘too clever by half” politics than sound economics.

 

GLENN STEVENS IS A GOOD CENTRAL BANKER

On 15 October he had, inter alia, this to say in an address given in Perth to the John Curtin Institute of Public Policy: "The Board is also conscious, though, that a risk-management approach requires policy to be recalibrated as circumstances change. If we were prepared to cut rates rapidly, to a very low level, in response to a threat but were then too timid to lessen that stimulus in a timely way when the threat has passed, we would have a bias in our monetary policy framework. Experience here and elsewhere counsels against that approach. "

"None of this is to say that the economy is, at this moment, ‘too strong’. It isn’t. "

"The point is, rather, that the very low interest rate settings were designed for a weaker economy than we are in fact facing. Plainly, the downside risks to which the Board was responding earlier have not materialised. This is not a problem. In fact, it is a very desirable situation. It is a welcome contrast to the experience of a number of other countries. It is simply something we need to recognise in setting monetary policy – which means not holding interest rates at very low levels when that is no longer needed."

 

MR OBAMA

… inherited an economy with a serious domestic deficit of $400 billion after Mr Bush inherited an economy with a budget surplus. In the year to 30 September 2009 that deficit is now $1,300,000,000,000 ($1.3 trillion). Now that deficit is said to be not serious because the economy is growing again. But the economy is only growing because of the stimulus package that has created the deficit. The US debate about raising taxes and interest rates has begun, and will accelerate. A bad war here and there, and a bad oil price, and a bad emissions trading scheme might just make matters more than a little difficult. We remain hopeful that Mr Obama’s swing to the left is just a necessary step in the long progress back to the centre. Debates about capitalism and socialism from the loonie left and the loonie right just means that too few of those involved have read Peter Drucker and/ or have mis-read Ayn Rand or David Stockman’s book " The Triumph of Politics, Why the Reagan revolution failed"

 

INFLATION, NOMINAL GDP, EPS and GROWTH

Earnings per share growth drives share price performance over the longer-term. Earnings come from real GDP plus inflation which is called nominal GDP. The multiple that we attach to EPS is derived from EPS growth, interest rates, and confidence. At the moment the debate on inflation also encompasses the view that deflation is more of a problem. A softer word for deflation is recession, and a harsher word is depression. We have avoided a depression through monetary policy and fiscal policy acting in an harmonic way. Inflation is a problem in Australia and deflation is more of a problem in America. We kind of like a bit (but not too much) of inflation…. house prices go up, asset prices generally go up, banks are eager to lend on enhanced values, wages are stable or growing etc. In relation to goods and services you can avoid inflation by saving or spending less. Global excess capacity should mitigate the impact of goods and services inflation but we will save an extended discourse on inflation for another day.

At the moment we think the expansion in Price Earnings Multiples exceeds the EPS growth potential for far too many companies. Refer to our Strategy section and our Stock Recommendations section. You will not see a large number of recommendations at current price levels. Either our macro settings and/ or our micro EPS settings are wrong, or too conservative, or prices are simply ahead of themselves. We believe the latter.