INTRODUCTION

Niall Ferguson is a highly regarded and entertaining historian and his latest book is "The GREAT Degeneration: How Institutions Decay and Economies Die." The book encompasses his Radio 4 Reith lectures of 2012 and our editor received the book for Christmas from a confidant of some standing.

We found it immediately relevant to our deliberations for calendar 2013 as it fitted observations that we had made over the past decade or so and scattered amongst our Ecinya Insights.

This book is highly recommended reading for students of history and of economics and stock-markets.

For our part we have referenced various parts of his treatise but that is no substitute for reading the entire manuscript to gain a total perspective and a more complete understanding.

 

FERGUSON’S PRIMARY FOCUS

…is the long prophesised decline of the West.

Jonathon Pain, a close Ecinya confidant, has long talked about the west as ‘Submerging’ and the East as ‘Emerging’. Pain also includes Brazil, other South American states and parts of Africa in his view of the ’emerging’ nations. Pain also regards the emergence of the Chinese middle class as the great phenomenon of his time. In relation to China we respectfully point out that in purchasing power parity terms China’s GDP per capita runs at about US$10,410 with America at US$51,525, Australia US$44,390 and poor old Greece at US$25,030. (Figures courtesy of The Economist) Message: China still has a long way to go.

Ferguson maintains that symptoms of decline are all around us: slowing growth, crushing debts, ageing populations, anti-social behaviour. He attributes this decline to degenerating institutions. In his words ‘Our democracies have broken the contract between the generations by heaping IOUs on our children and grandchildren. Our markets are distorted by over-complex regulations. The rule of law has metamorphosed into the rule of lawyers. And civil society has become uncivil society.’

Ferguson is not saying that this recognisable decline is irreversible. It is merely difficult and will take heroic leadership and radical reform. In major countries he sees no signs of leadership or reform, and in particular is negative on the United States. In the words of Robert Friedland of Ivanhoe Mines "The situation is hopeless, but it’s not serious."

 

Ecinya Observations

Longer term Ecinya opines that America will both survive and thrive BUT short term Ferguson is talking clearly about problems that are not clearly recognised and largely not understood by politicians intent on misleading the public voter. Ecinya believe that the markets have to fall if only to spark a crisis along Ferguson lines such that Congress and the White House have to develop viable plans for a US renaissance via a return to sustainable fiscal and monetary stability. Fiscal policy is currently off the agenda and monetary policy is proceeding on the basis of money printing in perpetuity with bogus targets on employment as the new catch-cry.

Writing America off has been a European academic preoccupation since the end of The War of Independence (1783) and yet it is Europe that has lost its relative and absolute place in the world.  If only stem cell research were more advanced we could bring back Queen Victoria and/or Winston Churchill and perhaps even Charles De Gaulle.

Europe seems a more intractable problem, but Europe does really need America to lead by example. Ecinya has never been fond of the Euro block nor the elites that have grown and prospered into corporate dynasties since the end of World War II. If America were to recover we can, we believe, tolerate European inertia and the world can visit the compelling sights of Europe as tourists and look elsewhere for material items to consume and throw away. The peaceful growth of Asia, some material advances in Africa, and continuing growth in modern South America will also assist. European arrogance is not much different than American exceptionalism…. "we are the greatest". Australia was once modest and succesful, but governments since 2007 have been pregnant with bluster, bravado, short-sightedness and a shallow bag of inflated statistics.

 

DEGENERATE … meaning of

"Degenerate" in our Collins Dictionary means ‘to become less specialised or functionally useless, having declined or deteriorated to a lower mental, moral or physical level; degraded, corrupt’.

 

AN EDITED EXTRACT OF FERGUSON’S CONCLUSIONS:

Countries arrive at the stationary state, as Adam Smith argued, when their ‘laws and institutions’ degenerate to the point that elite rent-seeking dominates the economic and political landscape. I have tried to suggest this is the case in important parts of the Western world today. Public debt – stated and implicit – has become a way for the older generation to live at the expense of the young and the unborn. Regulation has become dysfunctional to the point of increasing the fragility of the system. Lawyers who can be revolutionaries in a dynamic society become parasites in a stationary one. And civil society withers into a mere no man’s land between corporate interests and big government. Taken together, these are the things I refer to as the Great Degeneration.

Shortly before I completed this book, the president of the United States gave a speech that neatly illustrated the point:

"If you were successful, somebody along the line gave you some help. there was a great teacher somewhere in your life. Somebody helped to create this unbelievable American system that we have, that allowed you to thrive. Somebody invested in roads and bridges. If you’ve got a business – you didn’t build that. Somebody else made that happen. The Internet didn’t get invented on its own. Government research created the Internet so that all the companies could make money off the Internet……. There are some things, just like fighting fires, we didn’t do on our own……. So we say to ourselves, ever since the founding of this country, you know what, there are some things we do better together. That’s how we funded the GI bill. That’s how we created the middle class. That’s how we built the Golden Gate Bridge or the Hoover Dam.. That’s how we invented the Internet. That’s how we sent a man to the moon."

This surely is the authentic voice of the stationary state: the chief mandarin addressing distant subjects in the provinces. It is not that the implied interdependence of the private sector and the economy is wrong. It is the over-statement of the case that is disquieting.

 

Bud Conrad, Chief economist of Casey Research (source- financialsense.com) had this to say on 12 January 2013 and endorsed the Ferguson themes:

I had been trying to ignore the massive, blanketed coverage by our media of this political circus. I knew ahead of time what the result would be from this deficit-cliff exercise. When it comes to holding the line against more government deficits, spending, and taxing, our government is dysfunctional. This event is more seminal than the results indicate: we can expect the politicians to repeat this process in a couple of months, and so on until there is a major loss of confidence in the dollar. There will be no return to fiscal responsibility. My point is simply this: we are already beyond the point of ever returning to a sensible, balanced-budget system. We may be distracted by wars, some crazy or false-flag terrorist event, or by even a natural disaster, but the conclusion is already inevitable: The US dollar will be toast; Treasuries are a dangerous investment; interest rates will start rising; and even the massive Federal Reserve manipulation supported by the banking cartels will be unable to overcome that. We will likely start in a slow fashion this year and will escalate out of control in the decade ahead.

 

THE ECINYA SOLUTIONS

In our Ecinya 2008 Overview Insights paper we enunciated our ‘Enduring Obsessional Macro Themes, which seem still relevant today –

• The world, and stockmarkets, like growth.
• The world, and stockmarkets, like low real interest rates.
• Domestic deficits matter very much.
• Politicians and commentators should forget ‘capitalism’ and ‘socialism’, instead focus on ‘balanced free enterprise’.
• Similarly, we should forget ‘free’ trade, and focus on ‘beneficial’ trade.
• The Chinese Communist Party should change its name to something like ‘The China Central People’s Party.
• Think about what consequences might flow from an outbreak of relative world peace.
• America should, under a sound President, find a way to talk to moderate Islam.
• Religion should take a back seat in American politics.
• The National Rifle Association needs persuading that gun control reform is overdue. America should mitigate its tendency towards encouraging mindless violence.
• America needs to focus on retirement policy, education, tax reform and relatively affordable health care.
• American domestic policy should aim to grow and expand the middle class.
• America should assist the United Nations to become relevant.
• Australia should move to a 5 year Federal parliamentary term with a minimum of 4 years.
• Real tax reform is incomplete in Australia and a re-vamp should include extension of the GST to food before changing the capital gains regime and the income tax scales.
• Auditors should read aloud their annual report at the AGM to shareholders to remind themselves, the board of directors, and shareholders that they are responsible to the shareholders.
• All public companies with a market capitalisation over say $400 million should report their results annually four times a year. A June balance date would have their statutory reports at that date but also report for the full year ended September, December, March and then June.

 

Addendum to the above

Direct donations to political parties should be banned. It just creates crony capitalism and crony socialism. Politicians then throw largesse at ‘the base’ and give disparate crumbs to narrow interest groups. The result is the chaos and breakdowns that Ferguson has recognised. The alternative is that donations go to an Electoral Bank and the proceeds are distributed on a formula basis to accredited parties and accredited candidates. Independent groups can self-fund and self-promote provided they are subject to audit in monetary terms and accuracy in terms of campaign materials. Any independent can borrow from the Electoral Bank by providing security and then be refunded audited costs if a seat is won or a base level of votes is achieved to provide a partial refund of costs incurred. Crony capitalism gave us "Too BIG to fail" and "Too powerful to perish." It is highly likely that a proper enquiry of CitiBank and Goldman Sachs and perhaps others would result in some likely push for their break-up. Reference –http://www.rollingstone.com/politics/news/secret-and-lies-of-the-bailout-20130104.

 

FOR PEOPLE OF IMMENSE TIME AND PATIENCE WE RE-PRODUCE (with minor editing) OUR ESSAY OF JULY 2011

 

1) Adam Smith, at least, lived to have high hopes for the new country. He thought it was normal for human beings to want to live in a prosperous society, but that it was also normal for them to live in a broadly just society. Their desire for self-improvement was in many ways mysterious, but in the end it was inherently social, rooted not only in the love of acquiring but in the love of haggling, bargaining, interacting – the whole work of building worlds out of wishes. What then moved men to make markets was ultimately their love of pleasure and happiness, and who Smith wondered, could live happily in a society where all the wealth had been confiscated and kept in a few hands? He believed not that markets make men free but that free men move towards markets. This difference is small but decisive; it is most of what we mean by humanism.

AFR 29 December 2010 – Adam Gepnik of The New Yorker writing on Nicholas Phillipson’s "Adam Smith: An Enlightened Life."

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

Ian Macfarlane, Governor of the Reserve Bank, 14 June 2005.

(3) 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.

Peter Walsh former Labor Party Finance Minister, Financial Review 10 December 2003.

(4) 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 available and to use fiscal measures to boost employment and avoid the unpleasantness of downward adjustment 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 in "The Age of Turbulence", September 2007.

(5) Treasury was at its most influential during the term of the Hawke government, but I give credit for that to our greatest ever treasurer, Paul Keating, a man with a deep understanding of how to obtain and use political power, and who needed a purpose to fight for. Treasury supplied that purpose, affecting his conversion to economic rationalism. Treasury’s highest institutional objective has long been to dominate the economic advice going to the government, and no secretary has been more successful in this than Ken Henry, thanks to the arrival of the deeply insecure Rudd government, which sought to hide behind the authority of the supposedly independent Treasury.

Ross Gittins, The Sydney Morning Herald, 27 December 2010.

(6) Labor should just stop meddling with the markets: History shows Julia Gillard and Kevin Rudd always can be trusted to do the wrong thing……..Gillard, god bless her, is less inclined to write a treatise on economics during her holidays, but it would be hard to find someone less qualified to understand markets than a union lawyer who was a member of the Socialist Forum for the best part of her adult life. With Australia’s economic growth figures for the September Quarter on a precipice at 0.2 per cent, Gillard wants to introduce a tax on mining, the one thing that kept Australia out of recession these past few years, and then get to work on a carbon price….. and legislate against exit fees in home loans, a measure that non-banks assure us will make them less competitive. The truth is that the Gillard government has the same chronic problem that crippled the Rudd government: neither incarnation seems to have the faintest clue about markets. Watching them blunder through each fresh initiative leaves you with a feeling of helplessness reminiscent of being an audience member at a kid’s puppet show.

Gavin Atkins, www,asiancorrespondents.com, The Australian 28 December 2010.

(7) Global economic recovery more superficial than real: Liquidity injections and bailouts can buy time, but are not the solution for economies in need of structural repairs….. Time is not the answer for economies desperately in need of structural or fiscal consolidation, private sector deleveraging, labour market reforms, or improved competitiveness. Nor does time cushion anaemic post crisis recoveries from the inevitable next shock.

Stephen S Roach, Non-Executive Chairman Morgan Stanley Asia, Financial Times 5 July 2011.

(8) I contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket, and trying to lift himself up by the handle.

Winston Churchill

(9)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.

Emperor Qianlong of the Qing dynasty, 1645, outside of the The Hall of Central Harmony in the Forbidden City on signage sponsored by American Express:

 

OUR QUOTES EXPLAINED (90% of the message is in the head-notes).

(1) Adam Smith is most famous as author of "Wealth of Nations" and created the thesis that the ‘invisible hand’ of enlightened self-interest pursued by men of integrity would promote pervasive prosperity.

(2) Australia needs to regularly remind itself that it is about 1% of the global economy and act accordingly. Though we participate above our weight there is a recurring tendency for our political leaders to exaggerate our place in the world and pursue policies that are against the national interest and to squander the proceeds of our recurring cycle of resources booms.

(3) The Hawke-Keating-Walsh Labor trio got the balance about right and in their first term, and a bit of the second, the Hawke government advanced Australian prosperity enormously, overcoming much of the malaise and regression under the Whitlam and Fraser administrations. Mr Walsh from retirement has branded Mr Rudd an ‘economic illiterate’ and there is currently no reason to suppose that Ms Gillard is significantly different than her predecessor. Our current Treasurer Wayne Swan’s mantra is: ‘Because everybody disagrees with me that is proof positive that I’ve got the balance about right".

(4) Alan Greenspan’s memoirs are something of a mea culpa as he was a terrible central banker who failed to realise that bubbles were being created in the American banking system and too often pursued monetary policies to favour the White House President who had appointed him, sometimes out of fear that sacking him would cause stock-market, and re-election donor disruption. He has come to realise that America had become indulgent and profligate under his monetary stewardship, borrowing and printing money to pay for recurring expenditures including defence, war and welfare. It is the essential role of central banking to privately hold the government to account, and if that cannot be done, to do it publicly via interest rates and direct market mechanisms.

(5) Ecinya cannot entirely endorse Mr Gittins’ remarks on Ken Henry but we were interested to reflect on his use of the phrase "deeply insecure Rudd government", an observation which we wholeheartedly agree with. Mr Rudd seems destined to live and travel with his insecurities. However, at this point in time we can also find elements of ‘insecurity’ in both the Liberal alternative (a crazy paid parental leave scheme that missed shadow cabinet scrutiny, Mr Hockey remaining in the Treasury portfolio), and the incumbent Gillard-Rudd-Greens coalition where insecurity is evident in excessive debt loads, waste and extravagance. The Hawke-Keating-Walsh- Howard-Costello budget bonanza has gone. Mr Henry should have refused to undertake his Tax Policy Review without inclusion of the GST and to have protested the government response to the bulk of his recommendations. The obvious candidates for the Shadow Treasury portfolio are Scott Morrison and Malcolm Turnbull, but the latter often appears incapable of separating his ego from the national interest. Sometimes even worthy ambitions have to be put into life’s knapsack.

(6) Ms Gillard, Mr Swan et al are no students of Adam Smith nor, closer to home, of the past success of the Hawke-Keating-Walsh-Howard-Costello years. Government in Australia on a consolidated basis (Federal & States) is now running at close to 30% of the national economy, instead of a more manageable and balanced 20-22%, forcing the Reserve Bank into tightening when it should be able to think about reducing interest rates. Fiscal policy waste could have been channelled into sustainable tax reform, and structural initiatives. ‘Poor-girl-of- Welsh-origin-done-good’ is not a basis to run the nation; the job is bigger than that.

(7) Wishful thinking is the enemy of hard work, and Stephen Roach’s opinions are always worth a visit, though he is often prematurely prescient.

(8) and (9) need no explanation. The current Greek solution will fail and if it forms a template for other distressed nations then chaos will prevail.

A note on our quotes

One of our esteemed confidants, Compass, often complains that our head-notes take up so much of his (precious) reading time that he is exhausted by the time he gets to the Ecinya text and the underlying message. We beg to differ and believe the head-notes enhance the message, especially in context of our fulsome explanations. But there is "nothing more beneficial than an argument between persons of goodwill" and Compass remains a favoured and esteemed colleague. We do not seek his endorsement of our every remark, but thrive upon his perceptions and his oft well directed disagreements. Our text follows.

 

GDP BEING DRIVEN BY TOO MUCH ‘G‘

The thesis for this paper is that Gross Domestic Product (GDP) is being driven by too much "G"…… an excess of Government which is ‘crowding out’ the private sector. Small business resides in the middle class where most of the employment is created so that when you crowd out the private sector you crowd out the aspirational middle class. The result is simple – less velocity in the economy, less income growth, less economic growth, less employment growth.

The simple equation for GDP is

• GDP= C+I+G+Net Exports

GDP is the total market value of all final goods and services produced in a country in a given year, equal to total consumer (C), total investment (I) and government spending (G), plus the value of exports less the value of imports (Net Exports). GDP is adjusted for inflation using one of several inflation measures. In America it is the Implicit Price Deflator.

Over short periods the GDP numbers can be a bit rubbery, but in the longer-term they are reliable enough and when supported by other anecdotal and hard evidence, we can generally say the GDP is rising or falling at a specified rate. GDP growth is important because it is the source of company profits and company profits play a part in stock-market advances. Healthy growth in GDP usually means healthy profit growth, but if GDP is expected to fall then expectations take over and the forward estimates for profits and GDP influence share market outcomes. Perceptions of sustainable periods of economic growth lead to higher share prices. Such perceptions are called ‘confidence’.

Looking at world economic growth numbers from the IMF we see that world economic growth in the period 1992 to 2001 averaged 3.2%, and in the 8 years from 2002 averaged 3.6% but inclusive of a global recession of 0.6% in 2009. The peak years for growth over the last decade were 2006 and 2007 when GDP growth averaged 5.25%. In broad terms a 1% fall in GDP is akin to taking out of world growth about US$700 billion, about 75% of the entire Australian economy in purchasing power parity terms.

Another way of looking at it is, if the world economy grows at 3% per annum then it doubles about every 24 years, and at 4% per annum it doubles about every 18 years, a sizable difference.

Australia is a Federation of States and numbers are not available to us on a basis that consolidates the states and the Commonwealth, but numbers were given in a Ken Henry speech of 30 November 2009 that indicate that Government has become too large in Australia relative to the sum total of GDP. Because Government is funded by taxation, it is not being over-simplistic to state the following –

• more taxation = more government
• more government = less consumption
• less consumption = less production
• less production/ consumption = lower GDP growth

 

WHAT DOES THIS MEAN?

One of the great difficulties in the standard GDP formulation is that governments can increase their expenditures not only via increased taxation, but by increasing their debt. However, a couple of things result from this approach. Firstly, you have to pay interest on the debt and secondly at some future time you have to repay the debt. Ultimately, borrowings means that you have to have more income to repay debt and principal.

For government the only source of income is taxation as all of their other services generally lose money. Higher taxation causes big businesses to want to pay less tax or to reduce their costs of production. The easiest way for BIG companies to reduce their costs of production is to produce in lower cost countries. This means lower growth at home and over time can impact on the ability of a country to repay its debts in a timely manner. Then a debt downgrade results and a vicious circle begins. These processes take a long time to evolve and sometimes having evolved, take a long time to become a recognisable problem such as in Greece, Spain, Iceland, Italy, Portugal, Ireland, England, America etc.

A few weeks ago we had this to say in our Weekly Strategy Review –

The ‘approach’ from SAB Miller for Fosters could be a precursor to a number of foreign bids. Australia always has the ‘FOR SALE" sign up when we have bad governments. In today’s press (front page The Australian) David Murray ( ex boss of CBA Bank and now Chairman of The Future Fund) has aggregated federal and state debts to reveal that Australia’s government debts are growing at 7% compound per annum and will reach $550 billion by 2014. This will be the equivalent of about 42% of GDP. Murray’s view seems to be saying that we are on the Greek tragedy treadmill. Debt seems to be growing at about double a real rate of GDP growth of circa 3%, AND even that is built on a mining boom. Australia has a relatively narrow export base and an extremely broad import base.

Back in October 1985 Peter Drucker had this to say –

I think, there has been an irrevocable shift in the last ten years. No matter who is in government, he would no longer believe in big government and would preach cutting expenses and would end up doing nothing about it. This is because we, the American people, are at that interesting point where we are all in favor of cutting the deficit – at somebody’s else’s expense. It’s a very typical stage in alcoholism, you know, where you know you have to stop – tomorrow.

It is now apparent that Mr Drucker was an incorrigible optimist because the rhetoric that has come from the Blair, Obama, Rudd-Gillard-Greens governments is not anything about small government at all. The universal mantra is "Markets have failed. When markets fail, governments have to "step in". This is despite that fact that it was government inefficiency, poor policy formulations, and lack of oversight, that caused the markets to fail in the first place.

The failure of governments over the past two or three decades to follow simple economic rules is the structural and systemic problem that needs to be overcome. However, the hole is so deep that only a unified plan will shift the role of government back to the centre. Qianlong is speaking from the grave.

 

LOOKING FOR SOLUTIONS

To find a solution you need to firstly define the problem, then test, re-test, and test again.

The world is in the post-crash period and not enough has been done quickly enough, or constructively enough, to provide a solid foundation for confidence going forward. Confidence is built not upon optimism, but knowing how you will handle the worst if it should come along. Economic vandalism is always wrapped in the cloth of ‘fairness’, ‘compassion’ and ‘reform’. When governments are pretending to be economic pragmatists they add the words ‘tough decisions’ to the ‘reform’ process. We find it rather ironic that financial planners, solicitors, doctors, lawyers, chartered accountants, engineers have to complete ethics courses when politicians do not. They just take an oath of office that they frequently break to stay in power and preserve their various direct and indirect entitlements, in too many cases, but certainly not all.

The Global Financial Crisis came about due entirely to –

• Structural failure
• Systemic failure
• Cyclical factors

A quick summary of all of three points immediately above is ‘Government Failure and Chaos’ at all levels….. parliamentary, cabinet, ministerial, institutional and regulatory. The Zurich axioms say "Chaos is not dangerous, until it begins to look orderly."

In terms of structural and systemic failure we can blame the United Nations, the IMF, various central bankers, the shortcomings of the Euro-zone, Fannie Mae, Freddie Mac, Wall Street, commercial banks, ratings agencies, and history itself. But most of all we can blame GOVERNMENT in all of the developed economies and some of the developing economies.

Cyclical factors result from the ultimate realisation that structures and systems evolve that create the reality of success, but when excess evolves from that success, it is only the commentariat that says ‘enough is enough’. In the long expansion from circa 2000 to 2007 critical commentators were ignored and then summarily dismissed as ‘out of touch’, ‘doomsayers’, ‘bears’, ‘hidden agenda-ists’, ‘hysterical’, ‘myopic’, or ‘merely mad’ etc etc. Now they are often many of those things. The commentariat is frequently prematurely dogmatic, but this is better than being emphatically correct with the benefit of hindsight despite conspicuous silence during the excess growth/ bubble phase.

 

AMERICA

America is important for two main reasons. Firstly, it is world’s largest economy and secondly the US dollar is the world’s reserve currency.

In a recent luncheon meeting with Compass our Ecinya editor mouthed the spontaneous phrase "When the US dollar begins to rise the world will begin to normalise." Compass liked this so much, being a student of currencies, and frequently quotes it. Somebody once said "If you don’t like flattery, it just means you have never been flattered."

After World War II the US began to outsource a large part of its manufacturing to Europe as part of the Marshall plan, and then it managed the economic rehabilitation of Japan which became a major (and cheap) exporter to the USA, then South Korea came into focus after the end of the Korean war, then Taiwan, and now China. America has lost a lot of its will and capacity to manufacture and foreign countries have filled the gap. In a couple of recent visits to America our editor could only find one significant Wal-Mart department that seemed to carry mainly goods made in the USA… it was the toy department.

America’s success at exiting WW II as the world’s largest debtor nation appears to have encouraged it to spend rather than save. These expenditures have principally been on welfare, health and defence. America has also fought a number of wars which have gone over time and over-budget – the Korean War, the Cold War, Vietnam, Iraq and now Afghanistan.

As of June 2011, according to The Economist, America has a domestic budget deficit of 9.1% of GDP, a current account deficit of 3.4% of GDP and an unemployment rate of 9.0% (probably higher if properly measured). Now, all number are manageable in a world of fiat money, but they have to be actually managed. They can’t be left to themselves. there is no automatic repair system! The US political system has hit a position of gridlock and so the trend in bad numbers becomes more important than the numbers themselves. American politicians appear to have governed improperly for several decades, doing deals rather than controlling incomes and expenditures in a pragmatic fashion in the national interest.

President Obama replaced an unpopular President in George Bush and inherited the poor economic trends in evidence in Mr Bush’s second term. However, when Mr Obama came to power his mandate was free public health and it was probably unaffordable at the time. Certainly it was time consuming and while Congress blustered the economy burned . It would have been better if he had focused on the economy. However, the cult or myth of ‘American exceptionalism’ was allowed to prevail and jobs and the economy have only just become a priority, but with over-arching rhetoric substituting for an announced and broadly agreeable plan of action. In Mr Obama’s White House words speak much louder than action. Instead the growing, and somewhat encouraged, chorus is that "It is all China’s fault".

No doubt, the structural and systemic problems that Mr Obama inherited were worse than he could have imagined and advisers who pointed this out appear to have been ignored, mainly Paul Volcker. It seems a long time since America had a successful economic manager at the helm . From conversations and readings it seems that Truman, Eisenhower, Nixon in his first term, and Clinton have been the pick of the post WW ll economic managers.

 

THE WEALTHY DO NOT MAKE AN ECONOMY HEALTHY

Putting definitions to one side and ignoring comparisons in, and between, countries the most economically healthy countries are where the middle class exists and is growing. The three phases of a normal life are –

1. Preparation for a working life…. growing up, education, (say 20 years)
2. A working life……..skills development, building a small business or earnest vocation, creating a happy family etc (say 45 years)
3. Exiting a working life i.e retirement (say 20 years)

It is now clear to most of us that the State cannot provide the means whereby Stage 3 will be at a level consistent with the level of comfort and enjoyment you experienced in Stage 2, where relative youth enabled you to work hard and play hard, with holidays and leisure part of your primary pleasures. America has all but destroyed the middle class, and in many places Europe (except for the cash economy) is not far behind. With big business getting excessive subsidies and the poor getting excessive relief the burden of 20th century progress has been borne by the middle class. Show Ecinya a strong middle class, and an aspirational middle class, and it will reveal a healthy economy.

 

SO WHAT ARE SOME OF THE LESSONS FROM ALL OF THIS?

On the systemic side America needs a White House administration with an interest in business and economics which means the election of a President who can tell the difference between dud advice and good advice and the difference between good personnel and mediocre personnel. Most times people agree with the President because he is akin to the Pope. Papal infallibility and Presidential infallibility are close cultural, historical and psychological relatives.

Wall Street has to be brought to heel and get back to its original function of recognising and financing sound business ventures. This means less emphasis on derivatives and speculation generally. Probably a few people need to go to jail for past misdemeanours. American institutions have to be looked at from Freddie and Fannie and all the way to the Federal Reserve.

Structurally the US tax system is a shambles and this needs to change. Warren Buffett has long been an advocate of this.

America probably need to find a way to fight less wars or when it fights, win a just result with significant consensus, more quickly.

If Ecinya had to make just one big US adjustment it would be the banning of political donations and express limits would be placed on the cost and financing of elections.

 

EUROPE

Europe is a mess; get rid of the euro and its spawned organisations, and go back to nation states with their own sovereignty and currencies. Write off portions of the country debts in exchange for meeting austerity and recovery targets. Replace most of the left wing governments; suggest to the Greeks and the Irish that repairing damage from street riots is a misallocation of resources and costs jobs and mitigate recovery efforts.

 

 

 

 

The economic cycle, in simple terms, is the process of moving from an excess of consumer and investment spending to stability, and then to deficit. New spending then begins the next virtous cycle. If income is pressured, so is spending. Lower interest rates and lower taxes will drive the recovery.

Ecinya 23/2/2001

TODAY’S FRONT PAGES………

are telling us that the Federal Government is about to ditch the promise of a budget surplus. The budget surplus was always a figment of the imagination of an inept Treasurer who in previous budget reportings was able to ‘cook the books’ by bringing forward income or deferring expenditure, or accruing income for the next rainy day and charging current expenditures to a prior period. That game is over with recession in Europe and the possibility of recession in America and a major slow-down in Australia in the September quarter which will likely flow into the fourth quarter.

‘Cooking the books’ functions best in the broader context of fabricating the economics. This was almost certainly a bit easier when Ken Henry was Treasury Secretary, but may have now become more difficult under Treasury Secretary Parkinson. The fiscal promise of the mining tax has faded, the costs of refugee policy have accelerated, health and education revolutions and climate change ‘initiatives’ have been expensive and counter-productive.

Also as companies move their operations offshore to escape the harsh business climate that Australia has become, so do they move their tax base, and do not have to suffer the delays that come from visitational over-kill from Occupational Health and Safety bureaucrats and doyens of the environmental world.

And the consumer who has watched his superannuation diminish, interest rates and electricity prices rise and his income stagnate and his job prospects and/or job security reduce has suffered a loss of confidence leading to him repaying debt and also paying lower levels of taxation.

Mr Swan has always told us that he ‘has the balance right’ because people on both sides of the economic debate were disagreeing with him.

Where did it all go so wrong? Ecinya covered this in a number of past Insight articles, but two will suffice to tell the story –

The real GFC – Government Facilitated Chaos

 

A reflection: Australia and the global financial crisis

 

FISCAL AND MONETARY POLICY

Sound monetary policy cannot function at optimum levels without there being in place sound fiscal policy. Fiscal policy and monetary policy are natural dance partners and the systemic and structural failings that are evident in Europe, the Middle East and America have been hidden under the blanket of reckless central banking, softened by the euphemisms ‘money printing’ and ‘quantitative easing’. The ‘fiscal cliff’ in a fiat money world is probably the latest hoax to obfuscate and mitigate responsibility for poor political policy and fiscal vandalism.

At home our Treasurer and last two Prime Ministers Messrs Rudd and Gillard have squandered the Howard-Costello-Hawke-Keating-Walsh legacy and exposed us to the Asian consolidation or slow-down, depending on your definitional perspective. Macro fiscal policy settings have dented, and in some cases, decimated consumer and business confidence.

It is likely that quantitative easing will, with the benefit of self-serving hindsight, come to be regarded as having solved some or all of the problems. The reality though is that one silver bullet does not create a recovery. It will really be a combination of factors that herald the end of one cycle and the beginning of another. One of Ecinya’s confidants (Dog) is already of the opinion that QE3 has some traction. In our view the main reason that problems are solved is because the personnel who gave rise to the problems in the first place have left the dance floor (George W. Bush, Alan Greenspan, Tony Blair, Gordon Brown, Strauss-Kahn, various Greeks with unpronounceable names and forgettable Italians such as Berlusconi etc.).

Ecinya is ever hopeful that their replacements are in possession of the velvet gloves and the iron fists which will save the world from its currently perceived and allegedly complex dilemmas, which are generally referred to as ‘crises’ so that an elected official can pretend to be solving the riddle.

If you then add in the occasional war such as Iraq, Afghanistan, Syria and Israel and Palestine and the resultant refugee problems, you can then understand how misallocation of scarce resources can lead to various calamities. Then just for a dose of spice add in the odd weather problem such as Hurricane Sandy. Before you know it fiscal policy suddenly adds up to a mountain of debt and current account and domestic deficits stretching well into the future.

AND just as you were getting comfortable will all of that the big question of ageing and demographics comes into focus.

BUT IT WILL ALL WORK OUT IN THE END

Cycles come and go. Within the cycles there are waves. The world is in fundamenatlly good shape and better times lay ahead. Getting the timing right is always THE CHALLENGE.

 

Introduction

Over the last month there has obviously been a lot of news, particularly in the US around the election and its result and the focus on the fiscal cliff negotiations that have followed. However, from an investor’s standpoint very little has changed. In equity markets most were weaker in the early stages of November and recovered much or all that had been lost in the second half of the month, government bonds behaved similarly, only in reverse, as did the US dollar, and gold is still at the same price as it was at the end of October. With so little change in prices it is not surprising, but more than a little disconcerting, to see that the volatility index, the VIX, has quietly slipped down to a level of around 15. Throughout the secular bear market, which began in 2000, this measure has rarely been lower and all the subsequent increases in the VIX that have followed on from such low readings have been associated with equity market declines. Now is not the time for complacency and I continue to believe that a focus upon capital preservation, rather than chasing yield or return, will be the most prudent and rewarding course for investors to follow over the next six to twelve months.

Despite many markets having marked time over the last month and no changes having been made in my outlook for markets there are still a number of issues worthy of discussion. In this month’s Strategy Thoughts I explore the importance of investors knowing what they are paying for when it comes to portfolio construction and asset allocation through a concept known as ‘active share’. This was not a term I was familiar with until the middle of November but it highlights a shortcoming of the investment industry that I have long been aware of and have discussed many times in the past. That is  the tendency for fund managers and asset allocators to seek the comfort of the herd. This is ok during a secular bull market when a rising tide is lifting all the boats, but that is also the time when individual investors need less ‘professional’ (in that they are being paid for it) help. Through secular bear markets something quite different is required. I have also included some comments from John Hussman on why one should be cautious. His analysis of the current secular bear market and what returns can be expected will not sit comfortably with much of the asset management industry, but comfort and success rarely travel together for long in the investment business.

Finally I revisit the market performance of the largest company in the world, its recent ‘bear market’ and subsequent rally, and it’s so called ‘race to $1,000’ with a couple of other technology high flyers, and I have some follow up comments on oil and what it may be saying about where other markets may go.

‘Active Share’, know what you are paying for

The 19^th November issue of Barron’s contained an article that I thought fascinating, and it highlighted a problem in the investment industry that is close to my heart. The problem relates to the desire on the part of fund managers to only do what they think will be a little better than everyone else, not what they actually believe is right. I highlighted this problem almost one year ago in a Thoughts and Observations piece titled ‘Accuracy is not enough! Anticipating surprises would be!’ In that article I noted that Ben Graham, Warren Buffett’s teacher, grew increasingly concerned about the investment industry’s ‘obsession’ with ‘relative performance’ rather than a longer term satisfactory return. At a conference, after hearing a fund manager state that “if the market collapses and my funds collapse less that’s ok with me. I’ve done my job.” Graham responded:

“I was shocked by what I heard at this meeting. I could not comprehend how the management of money by institutions had degenerated from the standpoint of sound investment to this rat race of trying to get the highest possible return in the shortest period of time. Those mengave me the impression of being prisoners to their operations rather than controlling them.”

I then went on to comment:

Investors who are obsessed with relative performance naturally succumb to herding, they don’t want to be too different from the rest, unfortunately the result will generally be disappointing. Perhaps institutional fund managers don’t feel that disappointment if their tracking errors are low, but the disappointment will be felt by their underlying investors.

Investment success comes from continually questioning what seems comfortable and appreciating that it is everyone involved in a market that makes a market, and that it is their collected expectations that are efficiently and perfectly reflected in that market at any moment. But the expected doesn’t drive markets, it is surprises that do that.

 The Barron’s article highlighted that not only is this tendency on the part of fund managers still present, it is actually growing. The journalist, Beverly Goodman, had moderated a panel at a conference where professor of finance at Notre Dame, Martijn Cremers, spoke. Cremers had originally conducted research into ‘active share’ a decade earlier while at Yale but had recently updated his research. Goodman outlined just what ‘active share’ was:

Active share is a measure of the portion of a mutual fund’s holdings that differs from its benchmark index. In other words, it’s a measure of how actively managed your actively managed fund is. Stated as a percentage of the fund’s holdings, it takes into account both security selection and any overweighting or underweighting of the stocks in a fund versus the index. "One of the most important considerations when buying an actively managed fund is that you expect the fund to be substantially different from the index," Cremers says. "Active share tells you what percentage of the portfolio is different."

Professor Cremers defines any fund manager who has an active share of 60% or less as ‘closet indexers’. For a fund to truly be considered active it should have an active share measure of at least 80%. What I found most intriguing, and to a certain extent worrying, in the article was that fund managers have been becoming more and more closet indexers. In 1980 half of all US large-cap mutual funds had an active share of 80% or more, by 2010 that number was down to just 25% of assets being truly actively run. A similar, albeit less severe, trend to closet indexing has been seen in the small-cap world as well. This trend may be understandable even if it is not necessarily healthy for investors. As Cremers put it:

"As a manager, you want to avoid being in the bottom 20% or 40%. The safest way to do that, especially when you’re evaluated over shorter time periods, is to hug the index."

One problem is that as a result many investors are paying active fees for something that is not truly active. If all one wants is the index then there are now a myriad of very cheap options, as Vanguard founder Jack Bogle frequently points out. An investor should not be paying an ‘active’ fee for what is essentially a passive approach. The second problem is that research shows that those funds that are truly active, i.e. with an active share in excess of 80%, tend to outperform their benchmarks by one to two percent a year.

Obviously this does not simply mean that any fund that is markedly different from its benchmark is going to outperform, but the only way one can achieve outperformance is by being different, and also skilful. It also means that investors should worry less about short term swings in markets and performance and focus more on what truly drives markets and returns over the longer term.

This approach to active share should also be applied to broader asset allocation decisions. The only way outperformance of a broad global benchmark, across asset classes, can be achieved is by being different. Naturally this will be uncomfortable much of the time, but an investor should not be paying active fees for a manager or adviser who opts to ‘hug’ the index in the pursuit of comfort. As the current secular bear market continues to unfold, and long term returns continue to disappoint, it is highly likely that ‘active share’ will become increasingly examined and discussed. In an environment of low returns active fees for comfort seeking passive management will not prove sustainable.

Why be cautious?

John Hussman of The Hussman Funds writes an excellent weekly market commentary. His publication of the 26^th November, Overlooking Overvaluation, is well worth reading:

http://www.hussmanfunds.com/wmc/wmc121126.htm

His observations always tend to be longer term in nature than those of typical fund managers and in this publication he highlights just how far the US equity market is from being attractive over the long term, or put another way, just how far the US equity market is from being in the early stages of a secular bull market. I have pulled out a few of his thoughts on the US market;

·        Presently, on the basis of smooth fundamentals such as revenues, book values, dividends and cyclically-adjusted earnings, the S&P 500 is somewhere between 40-70% above pre-bubble valuation norms, depending on the measure. That’s about the same point they reached at the beginning of the 1965-1982 secular bear period, as well as the 1987 peak.

·         If presently rich valuations were to retreat again to undervalued levels that have accompanied the start of secular bull markets (see 1982 for example), stocks would produce yet another extended period of dismal returns. 

·        At present, the return of the S&P 500 over the past decade – though below average – has actually overshot what would have been expected in 2002. This reflects the fact that valuations today are still well above their norms. Unless we assume that valuations will remain rich forever, this doesn’t portend well for returns going forward.

·        A fairly run-of-the-mill normalization of valuations in the course of the present market cycle would imply bear market losses of about one-third of the market’s value, without even establishing significant undervaluation.

·        Still, it’s worth a moment’s consideration that “secular” lows (which we typically observe every 30-35 years, most recently in 1982, and that serve as launching pads for long-term market advances) have usually been associated with declines in normalized price-fundamental ratios to about half of their historical norms. Such an event even 15 years from today would be associated with an estimated annual total return of just 2.7% for the S&P 500 between now and then. Such an event a decade from now would be associated with a negative expected total return for the S&P 500 in the interim. And while it’s not our expectation, such an event in the present market cycle would make “S&P 500” not just an index, but a price target.

The secular bear market still has a long way to run either in terms of price decline, time, or more likely a combination of both.

From a shorter term perspective his conclusion is unequivocal;

“Stocks are overvalued, and market conditions have moved in a two-step sequence from overvalued, overbought, overbullish, rising yield conditions (and an army of other hostile indicator syndromes) to a breakdown in market internals and trend-following measures. Once in place, that sequence has generally produced very negative outcomes, on average. In that context, even impressive surges in advances versus declines (as we saw last week) have not mitigated those outcomes, on average, unless they occur after stocks have declined precipitously from their highs. Our estimates of prospective stock market return/risk, on a blended horizon from 2-weeks to 18-months, remains among the most negative that we’ve observed in a century of market data.” (Emphasis added).

Whether the next cyclical decline brings about valuations that could also mark the end of the secular bear market only time will tell. Either way, it currently seems prudent to be cautious about the outlook for the US market over both the cyclical and longer term secular time frame.

Why Secular moves occur?

Secular, very long term, moves in markets tend to last decades, as Hussman points out, and they travel from one extreme of long term valuation to the opposite long term extreme. This raises the very sensible question; why? The answer does undoubtedly have something to do with the overall state of the economy and the world but the overriding feature is the tendency of human beings to forget the past and to extrapolate the present into the future, and we do this through both good times and bad. Eventually at the end of the move the memory of the past has so faded that ‘new era’ or ‘this time it is different’ attitudes emerge. ‘This time is different’ was the title of Carmen Reinhart and Ken Rogoff’s ground breaking book on eight centuries of financial folly published at the depths of the GFC. They were both interviewed recently and one of Reinhart’s answers touched on why secular moves occur:

“You go through history and, in good times, the tendency is to liberalize. Then a crisis happens, and you retrench. But the retrenchment lasts only as long as your memory does, and memory is not that great. Not the memory of the policy makers and not the memory of the markets. So as you start putting time in between where you are now and your last crisis, complacency sets in, and you begin to be more cavalier about what your indicators or warning signals are showing. That’s the essence of the this-time-is-different syndrome. The debt ratios are X, but we really don’t have to worry about that; the price-earnings ratios are Y, but that’s not a concern.

And so, given that this is so grounded in human nature, I’m extremely skeptical that we will overcome financial crises in any definitive way. We may have longer stretches [without a major crisis], as we did after World War II during the era of financial repression, which grew out of the crisis of the early 1930s. Back then, you had a lot more regulation and clamps on risk-taking, both domestically and cross-border. But then we outgrew it. It was passé. Who needed Glass-Steagall?”

Markets are undoubtedly ‘grounded in human nature’. No matter how hard ‘they’, whoever they may be, try, markets are certain to continue to exhibit the same booms and busts. The important issue for an investor is to recognise this and to incorporate a secular perspective into asset allocation and investment decisions. The way one invests during a secular bull market has to be different to the approach during a secular bear market. This can easily be seen over the last dozen years, compared to the preceding dozen years.

Since 2000 the cyclical moves have dominated while the major markets of the world have largely marked time or declined. This was quite different from the late eighties through to 2000. Over that period cyclical selloffs, even those associated with the 1987 crash and the Gulf War could largely be ignored as eventually the longer term secular trend swamped those falls.

Buy Asia Now?

Jeremy Beckwith, formerly CIO with Kleinwort Benson and now CIO with online fund manager Nutmeg, writes regular blogs on investing and economics. Last week he wrote the following:

Buy Asia, 21 November 2012 

It has been well understood for some years now that the driving force of global growth over the next decade is most likely to be the rise of the middle class consumer in the larger emerging economies, mostly in Asia.  This argues for heavy exposure, on a long term or secular view, to Asian stock markets and those Western companies that are successful in selling to the Asian consumer.

This secular view does however, from time to time, encompass cyclical periods of weakness, and the Asian stock markets have endured such a period over the last year and a half.  Current price levels in Asia provide an excellent opportunity for investors to buy into the key secular trend at a cyclically opportune moment.

And across LinkedIn Jeremy sent the following:

‘Both the secular trend and the cyclical indicators say very loudly to BUY ASIA’

It is refreshing to see other commentators taking both a secular and cyclical view. However, whilst from a secular standpoint I do tend to share Jeremy’s view, cyclically I am not so sure. I have long maintained that many Asian markets saw their secular bear markets end in the early 2000’s when valuations were historically low. A new secular bull market is therefore at hand; my concern is that in many of those markets cyclical declines, even within a secular bull market, can be enormous. As an example the Korean KOSPI ended a secular bear market in early 2003 at a level of 512, the same level it had first achieved almost sixteen years earlier. From that low point it began a new secular bull market and the first cyclical rise saw it quadruple to its peak in October 2007. From there it’s cyclical decline, despite the secular bull market remaining intact, wiped 57% off the market’s value.

Apple Crash and the race to $1,000

I first discussed Apple and the amazing expectations that it was by then attracting, in the April 2012 edition of Strategy Thoughts.

I touched on the subject again the following month and concluded that discussion with:

Clearly there is some scepticism about the wisdom of this move on Piecyk’s part, again this further illustrates the near universal conviction that Apple can only go ever higher and therein lies the risk.

Apple, Priceline and Google race to hit $1,000-a-share mark, USA TODAY, 4 April 2012

The headline above captured the mood surrounding Apple in particular, and two other stocks whose prices had been rising earlier this year. Apparently the race was on to become a $1,000 stock. At the time Apple and Google were both in the low $600’s and Priceline was just below $750. Priceline had very nearly done it before, the online travel company soon after its initial public offering in early 1999, close to the crescendo of the tech boom, hit $990 a share. But then after the bust the shares fell to below $8 a share in late 2000. Priceline’s most recent assault on $1,000 began in late 2008, during the depths of the GFC with the stock trading in the forties. From there it moved up to its peak just below $800 almost exactly coincident with the rash of forecasts of $1,000. At its recent low the stock, rather than sprinting the last $200 to the apparently inevitable millennial mark, had fallen more than $200. Google’s run up too can be dated back to late 2008, but its price has only tripled over the intervening few years to its peak, a little later than Priceline’s, in the first week of October. Since then its price fell $120 to below $650 at its mid November low.

Apple’s run up and reversal has probably been the most widely followed, understandably given it is the largest company in the world. Its latest bull market can be dated back to very early 2009 when its price was briefly below $80 and from there it began its meteoric, and now widely publicised, rise to its recent peak in mid September at $705. Like Google, a little after Priceline’s peak and the media frenzy over the prospect of a $1,000 price tag. Apple’s reversal has been more severe than Google’s and steeper than Priceline’s as over just nine weeks it lost 28% of its value, or two hundred dollars a share, down to its mid November low.

Throughout the decline that Apple suffered in October the media was filled with upbeat interpretations of the decline in Apple’s share price with the following Seeking Alpha headline and comment capturing the popular mood:

Apple Below $600: Trick Or Treat?

The article appeared on the website on the 1^st November by which time the stock had fallen to just below $600 from just above $700 in less than six weeks. There was no sense of alarm in the article, it merely stressed the positive qualities of the company and comforted investors with the seemingly comforting observation:

 “Even good stocks experience healthy corrections from time-to-time.”

Over the years I have frequently warned readers of the danger of those two words (‘Healthy’ and ‘Correction’) when they are strung together to soften the damage that has always already been done. There really is no such thing as a healthy correction; it is an oxymoron when it comes to investing. No one is genuinely pleased to have suffered a loss of even ten percent, let alone twenty, or the twenty eight that the Apple decline turned in to. True buying opportunities, after sell-offs in the early stages of long and rewarding bull markets, are never seen as ‘healthy corrections’, rather they are always seen by the majority as the resumption of the miserable bear market that had in fact already ended. In the very early stages of any bull market the majority will always be looking for reasons to sell, not to buy, similarly in the final stages of a bull market the majority will always be looking for rationalisations as to why the longer term uptrend must still be intact. That is when the ‘healthy correction’ always gets trotted out. This is not to say that every time the term is used that the bull market is over, but it does indicate that it is ageing, and the early stages of all declines, that ultimately become devastating bear markets, are always hopefully seen as ‘healthy corrections’ by the majority.

A sign that at least some respite in the Apple bear market could be expected was given in mid November. An amazing reversal in investor attitudes was highlighted by the following headline on CNBC’s website; it appeared on 15^th November:

Apple Stock Hit by Panic Selling: ‘Someone Yelled Fire’

The article began with the highly charged and highly emotive comment:

“Forget the “fiscal cliff” the real panic on Wall Street is over Apple’s stock”.

Ironically the giving up on the ‘healthy correction’ line in favour of the more emotive ‘Panic’ and ‘Fire’ came the day before Apple’s share price began its best recovery since the stock peaked two and a half months ago. That recovery may now be rolling over.

It may be the case that the recovery of the last couple of weeks is nothing more than what could be called a ‘healthy correction’ to the bear market, or a ‘bear market rally’, but don’t expect to see that type of commentary on mainstream media until the bear market in Apple, and probably the broader market as well, is much more established and widely accepted. At such a time any bounce like that seen in Apple will be dismissed as nothing more than a ‘dead cat bounce’ or a ‘suckers rally’. This is the attitudinal backdrop found at the beginning of long term bull markets just as the healthy correction belief abounds at and through bull market peaks.

Oil and the market, a follow up

Two months ago, in the October edition of Strategy Thoughts, I included the chart above as a means of illustrating how, over the last few years, a decline in the price of oil, rather than being good for the stock market, has heralded a decline.

I concluded that discussion with the following comment:

More recently, and in another indication of the ‘breadth’ of the overall global rally deteriorating, oilsuffered another setback falling, so far, 15% to its recent low. Whether this is the beginning of anothersignificant plunge for oil only time will tell but again it is interesting that US equity markets are grimlyhanging on at the same levels they held when oil began its latest fall.

 

Since then, as the second chart above illustrates, the oil price decline has become more severe and now the market has joined in. When oil made its peak prior to the recent decline the Dow stood at 13,653 and it was still very close to that level when the October Strategy Thoughts was written and remained there for another couple of weeks. Since then the Dow fell a little over 9%, or more than 1,000 points to its mid month low. This should be a cause of some concern for all those who are hoping that somehow this time around lower oil prices will be a good thing for the market. As noted last month the deflationary forces continue to grow and it seems that the equity market is now picking up on that trend as well.

What about the inevitability of ever higher prices? (Or forecasts built on so called economic fundamentals?)

As the peak in oil prices was approaching last year the media was obsessed with the idea that they could only go one way – up!

The new geopolitics of oil, Financial Times, 6 April 2011

‘A new dynamic has emerged in oil markets that is likely to push prices on to a higher path in the years ahead than almost anyone had forecast a year ago. It relates to the now unfolding critical dimensions of what can be called the “new geopolitics” of oil.’

We now know of course that despite the fears being a wonderful extrapolation, they were unfulfilled. At the next, slightly lower peak in March of this year, a similar fear was present:

Oil prices: 10 reasons to be fearful, The Guardian 2 March 2012

The article began:

‘Oil prices have surged by more than 12% since the start of the year to hit $125 a barrel and some analysts see them pushing even higher to $150.’

Again, we now know that this is not quite what happened.

At least the International Energy Agency has recognised the difficulty in forecasting oil prices:

Long-Term Oil-Price Forecasting Is Highly Uncertain, IEA Says, Bloomberg, 12 September 2012

Forecasting oil prices beyond a year is “highly uncertain” because of the need for more transparent data from suppliers and consumers, according to the international Energy Agency. “Forecasts based on futures prices, surveys of analyst forecasts, forecasts based on a variety of simple time series regressions and other common forecasting techniques are generally inferior to the random-walk forecast, which implies that the best forecast of crude oil spot prices is simply the current price of oil,” the Paris-based IEA said today in its monthly Oil Market Report.

Unfortunately they may be being a little optimistic in implying that they can predict even one year ahead. History has repeatedly shown that despite some analysts knowing that they don’t know, they cannot resist extrapolating recent trends, and the longer the trend has lasted the greater the confidence in the extrapolation, and this is not only true in commodity markets. In oil the same behaviour has been seen at troughs, only then the extrapolation is usually for things to fall even more;

Undoubtedly there will be much learned discussion regarding supply and demand of all sorts of commodities, all with solid so called ‘economic fundamentals’ to back it up. Most of the time these forecasts will do no better, as the IEA pointed out, than random walk forecasts, but at extremes they are likely to be dead wrong.

Gold

Richard Russell, the octogenarian writer of the Dow Theory Letter has been, quite correctly, a bull on gold for much of the current bull market. He remains a long term bull largely due to his total fear of the Federal Reserve and their printing presses, however, even he noted recently that there may be a few too many Johnny come lately bulls:

“Over the last month there was too much eager talk about gold and silver. I was receiving a bullish mailer every day telling me about the fortune I could make by buying this or that "little-known" gold stock. So far, I’ve passed on all these fortune-making opportunities. Where were these guys ten years ago when they were giving away top-quality gold stocks? Investing is a strange business. They’re scared to death at the bottom and hot as a branding iron at the top.”

His description of ‘scared to death at the bottom’ and ‘hot as a branding iron at the top’ are neat descriptions of secular troughs and secular peaks. I would also note that I was intrigued to read this weekend in Barron’s that the correlation between gold and inflation over the last quarter of a century has been a staggeringly low 1%. This should provide very little comfort indeed to those Johnny come latelys stocking up on gold now on fear of inflation in the future. I remain very sceptical of the enormous gains that so many are now forecasting for gold. As Russell asked, ‘where were they ten years ago?’.

Conclusion

The last month has delivered nothing in the form of market action to cause me to change my very cautious outlook on the world. As I said in the introduction now is not the time to be chasing yield or return. What we have seen over the last month are numerous examples of the kind of market action and response that confirms to me that markets continue to be a wonderful barometer of aggregate social mood. It may make investors more comfortable to believe that somehow economics is going to tell them where markets will go but, unfortunately, that comfort comes from our deep seated desire to herd, and herding is a particularly unrewarding behaviour during secular bear markets.

The current secular bear market continues to unfold in many of the developed markets of the world and likely still has further to run in terms of both price and time. It is therefore not too late for investors to measure what they are getting from investment providers and to understand what they are paying for. ‘Active Share’ will likely become a more important consideration for investors as the secular bear market continues and returns in general remain low.

In closing I would like to wish all readers of Strategy Thoughts a happy and rewarding holiday period and would encourage them to visit www.bbbb.co.nz. This is my website that is now up and running. My book, Bulls, Birdies, Bogeys and Bears, is prominently featured on the site and readers can sign up to receive Strategy Thoughts at the site and also read archived editions. Naturally feedback would be most welcome.

This will be the last edition that I will be emailing out directly so please sign up on my website and let any of your friends, clients or colleagues know that this is available.

Afterthought

Several years ago I recommended a book by Frank Partnoy: ‘The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals’. It was published in 2010 and beautifully illustrated that whilst Bernie Madoff may have been a bigger fraudster than any of his predecessors he hadn’t done anything new. I have just finished reading Partnoy’s latest book: ‘Wait, The Useful Art of Procrastination’. It sheds some fascinating insights on everything from high speed trading to the invention of the Post-It note and towards the end he introduces the reader to ‘The Einstellung Effect’. In German the word Einstellung means attitude and the term Einstellung Effect refers to our tendency to get stuck in our ways ‘to act or think in the same manner we have always acted or thought, even when we are presented with alternatives that are obviously better.’ He points out that the best innovators do not develop such an attitude.

This is just as true for investors because as human beings we like to seek comfort, we herd. One of the ways Partnoy suggests of avoiding the Einstellung Effect is to avoid known, comfortable situations, or at least to be aware of their potential drawbacks. We all need to break out of our comfort zones but this is so hard. Partnoy quotes Keynes on this subject: ‘The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been,…. into every corner of our minds.’

The Einstellung Effect is undoubtedly powerful but just as all great innovators avoid it so too do successful investors.

One pleasing finding of the book is that, as the title implies, some procrastination can in fact be quite useful.

Kevin Armstrong

4^th December  2012

Disclaimer

The information presented in Kevin Armstrong’s Strategy Thoughts is provided for informational purposes only and is not to be considered as an offer or a solicitation to buy or sell particular securities. Information should not be interpreted as investment or personal investment advice or as an endorsement of individual securities. Always consult a financial adviser before making any investment decisions. The research herein does not have regard to specific investment objectives, financial situation and the particular needs of any specific individual who may read Kevin Armstrong’s Strategy Thoughts. The information is believed to be-but not guaranteed-to be accurate. Past performance is never a guarantee of future performance. Kevin Armstrong’s Strategy Thoughts nor its author accepts no responsibility for any losses or damages resulting from decisions made from or because of information within this publication. Investing and trading securities is always risky so you should do your own research before buying or selling securities.

INTRODUCTION

Ian Huntley now acts as a consultant to Morningstar having sold Huntley’s Investment newsletter to them some years ago. He is well known to our editor and both he and Morningstar have given permission for Ecinya to reproduce a recent article on ‘Dark Pools/ High Frequency Trading written by him on 1 November 2012. This is a topic that we are interested in, and interested in developing further views in the future. Ecinya is always concerned when markets adopt American practices that lack transparency and too often result in fears and tears for the retail investor, and indeed the market as a whole. We regard Ian Huntley as an earnest, experienced and honest commentator and observer of markets and take his views seriously.

 

Warning on Dark Pools, High Frequency Trading: Terrifying! – Review by Ian Huntley

The conclusion of Scott Patterson’s brilliant book Dark Pools is really all you need to know about the myriad algorithmic trading systems now running amok in our electronic stock exchanges, even worse now that Chi-X has joined the scrum using the most advanced electronic exchange techniques

Patterson describes one electronic advance: "In late 2011, for instance, NASDAQ rolled out a platform called Burstream that gave clients the ability to get data in six hundred nano seconds – six hundred-billionths of a second…In the options market nearly nine million orders flowed through the system each second, overwhelming computer programs and making a hash of trading information.

"That entire turnover was having a real-world impact on stocks. At the end of World War II, the average holding period for a stock was four years. By 2000, it was eight months. By 2008, it was two months. And by 2011 it was 22 seconds, at least according to one professor’s estimates." One prominent high frequency trader claimed a holding period of 11 seconds!

Patterson describes how these high frequency traders competed with each other for speed to the market, installing better connections, fighting to install their robots as close to the exchanges as possible – moves the exchanges aided and abetted in their lust for turnover.

Sub-titled, The rise of A.I. trading machines and the looming threat to Wall St, the concluding sentences are brilliant. A.I. is the label for artificial intelligence used to drive programmed robotic trading machines. Patterson quotes Spencer Greenberg addressing a high powered tech savvy conference saying that few were more knowledgeable about using A.I. to invest than Greenberg – the reason he was keynote speaker that day.

Greenberg warned: "Machine learning can be disastrous in the hands of people who don’t know what they are doing." And illustrated: "A terrifying example of this comes from a poorly planned military project that a computer scientist once told me about. A group of military technicians were attempting to rig an algorithm to distinguish between photos of a forest without tanks and a forest full of tanks. After training the system, they found it achieved remarkably good accuracy.

"But when the researchers attempted to duplicate the experiment, it failed. They then realised, late in the game, that in the original situation they had taken the photo of the forest without tanks on a cloudy day, while the photo of the forest with tanks had been taken on a sunny day. The A.I. was simply accomplishing the mundane task of noticing the difference between a sunny forest and a cloudy forest – it had nothing to do with the tanks at all.

"The horrific results of such a flawed system being activated in the field could only be imagined."

One can only conclude all these high frequency robotic trading systems should be banned and all stock exchanges should be required to shut off all links to them. And ALL orders in Australia, institutional and retail, should be routed through the one exchange. Send Chi-X off, complete with its ultra-smart electronic exchange tooling, so much in demand for HFT and all the rest of it.

The operations of HFT and dark pools have turned electronic exchanges into yet another alphabetic derivative style soup, akin to the concoctions that brought on the GFC. **

** Bold highlights in the last two paras are by Ecinya for emphasis

BACKGROUND

TAX REFORM is an on-going debate and it has now been re-ignited (GST, payroll tax, MRRT, carbon tax etc). Tax is always the most serious of debates as governments never spend or invest their own money, only that of their citizen taxpayers. Money spent or invested unwisely becomes ‘misallocated resources’. The result of misallocation of resources become ‘unintended consequences’. The greater the folly, the slower the recovery, or the deeper the recession.

Why is taxation now at the forefront of today’s debate? The simple reason is that actual government spending is increasing exponentially. Aspirational spending plans are increasing exponentially. With declining tax revenues, Federal and State debts are increasing rapidly. We have moved from surplus cash to deficit cash. And all of this is after a mining boom that seemingly has propelled Australia into the category of being ‘a rich nation’.

Our underlying structural budget deficit is a significant problem which Dr Stephen Anthony of Macroeconomics estimating that it will reach $120 billion by the end of the decade given current spending pledges.

A counter-argument to spending beyond your means that is trotted out on a daily basis is that our debt levels are low relative to GDP (gross domestic product), but that ignores the fact that our export base is deep and narrow, and our import base is deep and broad. Australia is hostage to world growth, particularly Asian growth, exacerbated by a small manufacturing base, declining productivity and the need to import capital which will demand a return over time.

Serious debates in Australia, particularly at the parliamentary level, cannot take place unless we address two important structural issues which appear to have fallen from the agenda.

They are –

• The need for an extended Federal parliamentary term
• Election funding reform.

 

 

EXTENDED FEDERAL PARLIAMENTARY TERM

It seems that modern Australia has been shaped by two governments that built upon the post-war foundations established by the long Liberal stewardship of Sir Robert Menzie (17 years) and briefly interupted by two outstandingly bad Prime Ministers in Gough Whitlam (3 years) and Malcolm Fraser (7 years). These two reforming and progressive governments were the Hawke-Keating- Walsh governments (9 years) and the Howard-Costello governments (almost 12 years).

Thus the Hawke to Howard era lasted for 20 years and the dominant thinkers and actors in this period were undoubtedly John Winston Howard and Paul John Keating. When Keating replaced Hawke in an internal coup the magic was gone and Mr Keating failed as a solo act, but without doing too much damage. Keating was lead violin with Hawke as conductor much akin to the Costello-Howard relationship.

Howard and Keating were the subject Paul Kelly’s excellent book, "The March of Patriots" published in 2009 embracing the theme that Keating and Howard were both rivals and unrecognised collaborators and seen together left an impressive legacy, but their work was incomplete and a little contradictory.

Modern politics and the emergence of less dominant, forceful, consistent, compelling and persuasive figures compared with the likes of Menzies, Hawke , Keating, Howard and Walsh means that period of constructive continuity may be a thing of the past. Both parties seem to be driven by poll results and hence expediency, and leaders are regularly turfed out by what appears to be relatively minor blemishes. Examples are Turnbull on climate change exacerbated by utegate; Rudd and his narcissism.

Ecinya’s structural pathway to better outcomes is that the Federal parliamentary term should be extended to 4 years with a minimum term of 42 months (3.5 years), or 5 years with a minimum term of 4 years., preferably the latter. The current 3 year term is too short and too often results in good policy badly implemented, or bad policy well implemented or, worse still, bad policy badly implemented. We are intuitively opposed to fixed terms believing that the government of the day deserves some flexibility in calling an election. The normal safeguard of an election brought about by a no-confidence vote, of course, would continue to exist.

 

ELECTION FUNDING REFORM

The paper we wrote on 11 August 2009 is reproduced below. We fully realise that it is imperfect and requires significant fine-tuning. But the danger is that if crony capitalism and crony socialism is not addressed then the malaise that is America will be inflicted upon us at some point in history.

 

‘Crony’: A friend or companion

Collins Dictionary

It is a mixture of money and politics that Australians have become accustomed to over the last decade. But this culture of paying for access has become increasingly problematic in recent weeks as lobbying scandals make headlines nationwide……….

Dick Warburton, a former Reserve Bank director and prominent company director, has had enough. He is scathing about the fund-raising culture that has developed in Australia. The former chairman of David Jones and Caltex says "it has become a racket"……………….

Warburton, as an elder statesman pulling back from corporate life, can be frank. For most others it would be a poor business decision to speak out against a system that both major parties rely on to fill their election coffers……………..

"Access can now be purchased, patronage is dispensed, mates and supporters are appointed and retired politicians exploit their connections to obtain ‘success fees’ for deals between business and government," Fitzgerald told an audience in Brisbane last month.

Australian Financial Review 8/8/2009 "Democracy For Sale."

With Labor governments mired in cronyism as established fact all up and down the eastern seaboard, the emerging irony is this: it may yet be the Liberal Party that emerges to save what reputation for decency these shabby outfits have left.

The man most likely to restore Labor’s moral compass at both the state and federal level is Michael Ronaldson. Ronaldson is well known in Victoria, but less so outside that state. He was Malcolm Turnbull’s numbers man against Brendan Nelson. He remains part of the Opposition Leader’s inner coterie. Which means he’ll be a busy man this week.

He’s survived cancer and still smokes. That makes him a mug when it comes to his health and I’ve told him so. But he’s no political mug. A direct talker in the Australian tradition, he’s known almost universally on both sides of politics as "Ronno". He’s determined; when cancer felled him he was forced to retire from his seat of Ballarat. That was in 2001. He came back to Canberra via the Senate in 2005.

And he knows a crooked system when he sees one.

The "crooked system" I refer to is campaign financing. And as it turns out, as shadow special minister of state, it’s the system Ronaldson has responsibility for. When Labor’s moral warhorse John Faulkner asked for and was given the Special Minister of State portfolio by Kevin Rudd after Labor’s 2007 election victory, he was on a mission to clean up political funding in Australia.

Because, like Ronaldson, Faulkner recognises that all those rent seekers in suits, sitting sleekly around the likes of Joe Tripodi in Jordan’s Seafood Restaurant outside the ALP conference at Darling Harbour a fortnight ago, are bad news for the democratic process.

Glenn Milne writing in The Australian 10/8/2009

To talk about economics requires more and more, that one write about politics.

Paul Krugman "The Great Unravelling" 2003.

ECINYA TEXT

ECINYA has long believed that Australia had the opportunity to adopt the best of Britain and the best that America has to offer. Though we are fighting the ‘good fight’ and generally winning, the opportunity to adopt the worst of both of these countries’ cultures is alive and well. One of Ecinya’s enduring obsessions is that the 3 year Federal parliamentary term leads to poor policy formulation and, too often, poor execution. The daily battle between scarce resources and unlimited wants and needs in context of tight political deadlines all too often leads to poor outcomes. The formal expression of this is ‘misallocation of resources.’ In a parliament as dysfunctional as our current parliament, with a Leader of the Opposition on training wheels, and a Prime Minister full of bellicose bluster sprouting economic hog-wash in local and global forums and writing convoluted essays, the problem of misallocation of resources looms as potential policy failure.

Towards a solution

Crony capitalism is one of the factors that has brought the United States of America to its economic knees. We should be consciously aware of the American model.

The recent debate surrounding alco-pops demonstrates the dilemma faced by politicians. We assume the alcohol, pubs, gaming industry are keen supporters of democracy and offending them might be dangerous for many, although we doubt that sports sponsorship leads to binge drinking, except for the highly paid sports stars themselves, and that might be a function of their income rather than advertising sponsorship. The recent revelations of connected and vested interests in Queensland is but another example of a system veering towards the American model.

How about Australia leads the world in electoral reform, and its hand-maiden, electoral funding transparency

Australia creates The Electoral Bank Fund ….. it collects donations made by interested parties, corporations and individuals, which are tax deductible, and also the Treasury makes a contribution as well. The funds are invested and earn a return between elections.

Once the election is announced, sitting members receive an allocation of funds on some formula basis, and pre-selected candidates do as well.

Any such candidate can ask for extra funds provided he/ she puts up some adequate security. Moneys spent on winning or losing an election that are not reimbursed become tax deductible.

An independent candidate can also borrow funds on a secured basis and contest the election. They will have a portion of his/her loan dissolved, provided they win a certain number of votes. Perhaps they have to win say 5% of the votes to qualify for dissolution of portion of their loan. If they were to win outright, or to win say 25% of the votes, their loan would be extinguished in its entirety, subject to some defined limits. Bribing voters by cash payments would not constitute ‘allowable expenditure’. ‘Allowable expenditures’ would have to be subject to adequate audit and verification.

Candidates would not be able to use funds provided from any source, be it union, corporate or otherwise.

All fund raising activities would have to be accredited and the funds remitted to the Electoral Bank. Fund raisers could nominate a beneficiary of their efforts, but it would not necessarily be binding upon the Bank Trustees, except in the case of an independent where, subject to source, extra funding might be allocated irrespective of win or loss.

For relatively safe seats funding might be scaled to reflect the realities that a loss is unlikely so that contestable seats are ‘over-allocated’ funds wise.

Obviously, we at Ecinya, do not have the experience or the information to know how to design the system in its entirety to make it workable BUT this brief essay may contain the germ of an idea that might just work to keep our democracy healthy.

In passing, we note that the major candidates in the last American election spent over $1 billion: circa $730 million from Obama, about $330 million from the McCain camp and about 4 independents spent another $60 or so million.

In Australia, the last election was our most expensive ever, according to Google, and some $163 million found its way from the private sector back to the private sector.

Resources are scarce; if they are allocated according to patronage the outcomes will be sub-optimal. State governments are struggling for revenues and the Federal government has become significantly interventionist, ostensibly sanctioned by a dead prophet in John Maynard Keynes. It is relatively clear that the Federal government is keen to get to the polls on an exaggerated debate about climate change after winning the second-hand Toyota utility truck debate. Additionally, we are going to soon have a limited debate about the meaning of tax reform as the Henry report arrives before the next election, which will presumably be aimed at replenishing public coffers. Electoral funding and favours asked for and given, seems an important issue for taxpayer scrutiny, for in the end they pay the piper for his tune. The ‘tune’ is estimated to be something above $200 billion of public debt. If this debt achieves little because a lot of it goes to cronies, then that would be a monumental waste of resources.

The success of the exceptional Hawke-Keating policy, compulsory superannuation, demands corporate transparency. If we do not have transparency at the top of our political system, it is hard to imagine that it will exist in sufficient quality in the middle and at the bottom. Electoral reform and an extended federal term is long overdue.

 

THIS INSIGHT ESSAY

This paper is written with the aim of articulating where markets might be headed in the pre- and post-Christmas period and into early calendar 2013. The contemporary and simple truth is that none of us know what is really going on and the commentary has entered the speculative zone.

At such a time, and they have occurred before, primary fundamentalists like ourselves have to resort to technical and quant analysis. What is the market telling us? In short, the market is telling us to be careful. Also at such a time we are compelled to visit our rules. The Ecinya Market Rules and 3 others are contained in our section ‘Market Wisdom’.

Our hunch is that a correction in major index terms of around 10% is imminent and it could go further IF Kevin Armstrong is correct, as he is anticipating something more dire than we are. According to one of the Zurich axioms: "A hunch can be trusted if it can be explained". John Maynard Keynes thought that it was not uncommon to hit on a valid conclusion before finding a logical path to it. We know from past experience that all information is ambiguous, but we can still function, albeit uncomfortably, in a sea of uncertainty. However, the aim at such times is to articulate the uncertainties that can be recognised and then see how they play out.

Economics has moved from the ‘dismal science’ to the ‘fragile science’ and markets are being driven by recklessly experimental central bankers rather than corporate and fiscal fundamentals. Fiscal and monetary policy are natural dance partners, but only monetary policy is on the dance floor. Can Obama re-invent himself? Is Romney/ Ryan the answer? There are a lot of balls in the air and ONE BIG BUBBLE……. the Fed’s and the European Central Bank’s respective balance sheets. Can the people who were asleep at the epicentre of the chaos find a way out, or are there sufficient personnel changes occurring, or in prospect, to herald new beginnings?

We know that genuine investors at both the retail and institutional level are confused. We know that market turnovers are relatively light. In relation to our oft used acronym ‘ICE’ (Interest rates/Confidence/Earnings), we know that interest rates need to fall in Australia, are historically low in America, are volatile in Europe. We know that confidence is low in most parts of the world as job insecurity is high, income growth low, unemployment is high, American GDP is lacklustre at best, Europe is in recession, Asia is slowing. We know that corporate earnings are being driven more by cost cutting than sales growth.

Are we there yet? Does reckless lead to wreckage or recovery?

Reckless governments, reckless commercial and investment bankers have now been replaced by reckless central bankers with the grand-daddy of them all in the third incarnation of its Bernanke-led QEs – Quantitative Easing. The first two QEs have not had any discernible impact on the real economy. There are two economies – the real economy: the production of goods and services; and the symbol economy: money and credit. The symbol economy is the tail that has wagged the real economy dog for far too long. Governments have abandoned viable fiscal policy out of fear of not being re-elected. Central bankers, acting as quasi politicians, have ushered in an era of speculative hedge funds and myopic and or quasi- fraudulent investment bankers (Goldman Sachs being the most dominant and prominent) and the result is mispricing and malinvestment. The Fed balance sheet may be a ‘bubble’.

"Are we there yet?" is the statement that impatient children make on their way to an adventure or holiday destination. In market terms ‘Are we there yet?’….. our answer is NO on a risk adjusted basis.

"Does reckless lead to wreckage or recovery?" Our answer is that it leads to recovery, but we might (and probably will) have at least one more bout of wreckage along the way. Progress, recovery will not be linear; sustainable outcomes always require reversion to the mean!

DIVERGENCE …… Kevin Armstong regards Ecinya as being far too optimistic at this point in time. Refer to –

• Don’t Chase Yield! And don’t believe in the ‘Music Man’!
• Can all news be good for the market, whatever it is?

 

FORECASTS, PROJECTIONS, OPINIONS, WISHFUL THINKING, MERE GUESSTIMATES – our current listing

Economists

1. Economists are slowly and deliberately winding back their estimates for world growth in calendar 2013 and 2014 (Westpac and other forecasts)
2. Economists adjust their final positions slowly to avoid admitting the recurring error of their models and a desire to not deviate too sharply from the positive spin of upper management (Ecinya and Armstrong opinion)
3. A world recovery needs a refreshed and re-vitalised America. Asia cannot carry a world recovery especially in per capita terms (Well held Ecinya opinion)
4. The IMF calling a world recession would be a sign of a significant bottoming as this organisation is woolly in prospect and retrospectively wrong in a timing sense (Ecinya opinion, the IMF is a contrary indicator)

Australia

1. Australia needs a federal election a soon as possible (Ecinya opinion though widely shared)
2. Ms Gillard is our worst post-war Prime Minister and Mr Swan our worst post-war Treasurer (Ecinya opinion)
3. Public debt is a big problem getting worse exponentially (Forecast by David Murray ex Commonwealth Bank and ex Future Fund Chairman)
4. Messrs Abbott, Hockey, Bishop and Pyne are a weak front bench making the Libs vulnerable to electoral defeat (Ecinya opinion recognised early by Editor’s spouse and confirmed in recent opinion polls)
5. Turnbull would make a viable Treasury spokesman provided he agreed with Abbott that the carbon tax and the MRRT had to go and an emissions trading scheme makes no economic sense (Ecinya opinion)
6. Australia needs a genuine reform programme in industrial relations and Joe Hockey would be a good Industrial Relations minister (wishful thinking and Ecinya opinion)
7. The NBN, the Gonski report, and the National Disability Scheme are unaffordable nonsense under an inept government and given the inherited problems of NSW, Victoria and Queensland (Forecasts and opinion)
8. The Asian Century White Paper is a monumental con job (Ecinya and others opinion)
9. Proper tax reform including the GST taxing food and changes to capital gains taxes and removal of many state taxes such as payroll tax would re-define the role of government in Australia and lead to a sustainable economic recovery and growth (Ecinya opinion)

America

1. American economic statistics are showing signs of improvement (Ecinya data base)
2. Obama has been an unfortunate failure as an economic manager and a victim of his own lack of fiscal experience (Ecinya opinion)
3. His predecessor, George W. Bush, was an even worse economic manager (Ecinya opinion but shared by notable observers including Paul O’Neill who Bush sacked as his first Treasury Secretary)
4. America needs a manager not another messiah, and Mitt Romney and Paul Ryan are the only potentially viable alternative product on offer (wishful thinking as it relates to ‘viable’)
5. Obama looks like the experiment that Jimmy Carter was after Richard Nixon lost the trust of the American people (Ecinya opinion)
6. IF Romney and Ryan win, the US market and markets generally will have a wishful thinking Christmas rally that may run into the early part of 2013 (Ecinya forecast, opinion and guesstimate)
7. If Obama wins he will have to quickly refresh his economic team and move from homilies and folksy platitudes to truth and policy (Ecinya opinion)
8. A sustainable bull market could start around SP500 in the range 1250 to 1350 on current reckonings in late March or April 2013 (Ecinya quant and technical analysis plus wishful thinking plus guesstimates)
9. America’s woes are entrenched, systemic and structural, attitudinal and psychological, and will not be cured by daily rhetoric about American exceptionalism. A back to basics approach is required (Ecinya opinion)

Europe

1. Europe is a basket case except for Germany – and some of the smaller cohesive nations – and something dramatic will happen in the new year (Westpac forecasts, Ecinya guesstimates and opinion)

Asia/ Middle East

1. The Middle East is a significant problem with no signs emerging of stability or progress (statement of the bleeding obvious)
2. China is a bigger worry than yet realised and unfolding political tensions and corruption allegations are a big problem (Opinion and forecasts starting to be widely reported)
3. China needs to change the name of the Chinese Communist Party to something like ‘The China Central People’s Party’ (Ecinya opinion)
4. India is slowing down (Westpac forecasts)

 

Comment on some of the above – imported commentary in italics

A test of SP500 around 1500 considered a pre Christmas possibility.

The Bo Xilai saga and the new revelations of the Wen Jibao $2.7billion of hidden riches is a big negative story. In The Sydney Morning Herald of 30 October 2012 it is reported under the head-note ‘China’s factions in struggle for power’ that China’s imminent leadership transition is descending into chaos, say some analysts, amid rolling scandals and signs of factional infighting between the current President and his predecessor. As Communist Party leaders converge on Beijing for a fortnight of crucial meetings centred around the 18th Pert Congress which starts on November 8, party insiders say fresh infighting has erupted over the future of the rising star Li Yuanchao. When Ecinya visited China in 2005 a prominent executive said "George, you must understand in China we have no small problems, only big ones." Editor asked ‘What is the biggest problem?" His response : "Corruption."

The word ‘Communist’ is a major impediment to improving relations with the west, and a change would signal that the 35 year resurgence of China was ready to take on a new impetus and more mature direction.

THE Gillard government white paper on Asia is a fraud. On every level, it is a con job. The government is having a lend of us. Its only admirable quality is its chutzpah……This pathetic and obsessive list making is a sign of a deep intellectual insecurity. It’s also a sign of government failure. Much of the paper itself, and many of Julia Gillard’s statements regarding it, are banal recitations of the obvious. By golly, Asia will have a big middle class by 2025 and that middle class will have a lot of money to spend. We hope they spend it in Australia. But beyond these windy cliches and vague generalisations, we are entitled to ask of this government: where’s the beef, Jack? The answer is, there is no beef.

Greg Sheridan The Australian 29/10/2012

Julia Gillard’s Asian Century White paper is a bizarre cocktail of the statement of the bleeding obvious, and a damning, if totally unintentional, critique of her government, its policies and its politics. Both the contradictions and content are so shallow that if it were a pool of water would pose no danger to a month-old baby lying on its belly, and is hardly surprising given the White Paper’s author – Ken Henry.

Ross Gittins The Telegraph 30/10/12

Reading the white paper called Australia in the Asian century is a very surprising and uplifting experience; it lists all these wonderful things that are going to happen to our nation by 2025…… There are 25 such wonderful points in the white paper, covering every aspect of Australian society and government, and all of them announcing some excellent thing that is going to happen, using the word "will". Isn’t it great? Why wasn’t I told all of this was going on? I mean to pull this off within 13 years, there must have been secret armies of people beavering away in Canberra on fixing our education, tax, and regulatory system for a decade already. Oh. they haven’t been? The white paper is just another wish paper? Damm.

Alan Kohler The Australian 30/12/2012.

Ecinya comment: Ms Gillard and Kevin Rudd spend an enormous amount of time and energy in the world of fantasy, hubris and outright delusional behaviour. We think it comes from the fact that having attained high office they believe their words have meaning well beyond their capacity to deliver and also spring from a fundamental misunderstanding of how business and economies work, function and create. Government is too often the province of people who have achieved little outside of the narrow sphere that is politics. Seymour Hersh described this delusional insanity in his book "Chain of Command, the road from 9/11 to Abu Ghraib" –

There are many who believe George Bush is a liar, a president who knowingly and deliberately twists facts for political gain. But lying would indicate an understanding of what is desired, what is possible, and how best to get there. A more plausible explanation is that words have no meaning for this president beyond the immediate moment, and so be believes that his mere utterance of the phrases makes them real. It is a terrifying possibility.

 

 

BACKGROUND

Much of the above are familiar themes as fundamental change occurs slowly…. some extracts from recent Ecinya Insights

Economic forecasts are being wound back fairly dramatically as practitioners have realised that they have got their 2011 forecasts wrong as Bernanke’s stimulus bounties underwrote the 2010 recovery. Take away the drip feed and the patient dies. As an example world growth according to Westpac Economics latest projections is expected to average 3.5% over calendar 2011 and 2012 compared with 4.2% just 3 months ago. The circa 1% difference is about US$700 billion in real terms. Fears of double-dip recession are expressed daily from reputable sources. America is struggling on all levels – fiscal, monetary, militarily, national identity; Europe has a banking and sovereign debt crisis, Japan is recovering from a natural disaster and years of almost zero growth, the Middle East and North Africa are at various stages of civil war. Strife abounds, which in simplistic terms means we are in the early stage of the opportunity cycle. Though there won’t be much evidence of recovery in calendar 2011, if policy makers work hard and politicians start to behave like adults and each communicate well, then the world should experience a normal recovery in the last 3 quarters of 2012. "Is austerity or reflation the pathway to economic recovery?" Our answer is – both are required, but with the weight on the reflation leg.

Ecinya: 7 October 2011 "Is austerity or reflation the pathway to economic recovery"

Today’s Comment: It turns out that we have thus far been wrong in that a normal recovery has not transpired in economic terms though in market terms calendar 2012 has provided opportunities for both investors and traders. A normal cyclical recovery should manifest itself sometime in 2013, but it would need to be driven by sound fiscal and monetary policy not yet in evidence.

 

Optimal outcomes demand that that ‘somewhere’ is at, or close to, where you want to go. Success hardly ever requires absolute precision and 95% of the time near enough is good enough. But keep in mind Peter Ustinov’s statement – ‘I love the guy who aims low and misses’.

CONCLUSIONS –

• Europe can’t YET go forward.
• China can’t go back.
• America needs to work out where it wants to go.
• Australia needs a federal election as soon as possible.

Ecinya: 13 April 2012 "All roads lead to somewhere"

 

In March 2007 when Premier Wen Jibao of China uttered the 4 ‘UNs’ at the National People’s Congress we assumed he was talking about the Chinese economy being ‘unbalanced, unstable, uncoordinated and unsustainable.’ Perhaps in his Confucian wisdom he was also talking about the global economy. Whatever, these 4 UNs have now permeated most of Europe and are well in evidence in the USA. and evolving in Australia. About 50% of world GDP is under threat or experiencing significant volatility. At a time of greater crisis, after the end of World War 2, led by the economic architecture promoted by Eisenhower and Churchill, the world recovered. The induced austerity of war-time shortages and putting the people to work in re-building Europe and other war-torn areas created large debt loads from the required massive infrastructure spend. Things changed because they had to as they must now. But all change is incremental and bad/ ineffective local and global leadership is not helping. A dose of truth, less innuendo and obfuscation might help.

Ecinya: 8 June 2012 "The four UNS: Unbalanced, Unstable, Uncoordinated, Unsustainable."

 

 

 

 

 

 

Kevin Armstrong’s Strategy Thoughts

November 2012

Confidence, Expectations and Markets!

Introduction

Over the last month markets have broadly meandered sideways and in so doing they have continued to deliver the ‘frustration’ that I discussed at length three months ago. Bulls on both bonds and equities have had both some good days and some bad days, and the same has been true for bears, but on balance there has been no resolution as to whether the action of the last few months has been the cresting of a bear market rally or an extension of a now fairly aged cyclical bull market in equities. Or the end of a very long term, secular, bull market in bonds. Amid such frustrating periods the most important thing an investor must do is avoid becoming frustrated. This may sound like a statement of the obvious, however, it is very easy to get swept up or down in whatever may have occurred over the last few hours or days. As the action of the last few months has illustrated, this is unlikely to prove rewarding. None of these frustrating movements have caused me to alter my outlook for asset markets and therefore my very cautious strategy has not changed. I worry about returns across virtually all asset classes and so continue to focus upon capital preservation. Having said that I do consider the recent action of commodity prices to be of some concern and I also worry about the apparent comfort that is being taken as a result of improving consumer confidence surveys.

In this month’s edition of Strategy Thoughts I explore both of these themes and conclude that there are likely some important cyclical and potentially secular messages in both of them. I also review the outlooks for gold and inflation (or deflation), not from an economic standpoint but from an ‘expectational’ one.

I have often ridiculed the efforts of investors to build an investment strategy and outlook based upon economic forecasts. This isn’t because I don’t believe anyone can forecast the economy, some analysts do have a decent track record, rather it is because determining what even a perfectly correct forecast will mean for investment assets is the real art. Markets throughout history have both risen and fallen apparently as a result of similar, or even identical, economic outcomes. The reason for this is expectations, and they are notoriously difficult to measure but ultimately they are what drive markets. A 4% GDP number may be seen as outstanding if expectations were for 3%, but equally it would be a disaster if 5% or more were expected. Still investors strive to construct an economic scenario upon which to base their investment strategy. This is because as human beings we hate uncertainty and so take comfort in a seemingly sensibly argued economic rationale, generally that comfort is misplaced, especially as the more comforting rationales tend to be the most widely held (we are herding animals) and therefore must already be reflected in the market. Another challenge is that expectations are constantly changing, often, and understandably, as a result of movements in the market about which those expectations are held.

Confidence surveys obviously attempt to divine where expectations are, this aim is admirable, but by the time they come out that ‘snapshot’ is frequently weeks out of date. Markets will already have reflected these changes. However, whilst broad consumer confidence surveys may only tell us what the markets already knew some weeks prior, surveys of CEO confidence may be of more value, but more on that later. First I want to look at gold and then some glimmers of hope, from an expectational standpoint, that the secular bear market that began more than twelve years ago, may be closer to its end than its beginning and possibly its middle.

Gold

In order to gain a useful perspective on the gold market it is important to take a long term view and it is also important to understand just what drives the price of gold. It obviously is not valuation, gold doesn’t pay any dividend or coupon and it doesn’t earn anything on a per share basis, it also is not inflation, contrary to popular belief borne out of the inflationary seventies, gold has risen through both inflationary and deflationary periods throughout history. And it is also clear that interest rates are not gold’s primary driver, the argument has been that the lower rates are then the less one is giving up to own gold and so its price should rise. This is a nice neat rationalisation, it seems to make sense, and yet over the last year, while it has become increasingly clear that the US Federal Reserve is going to keep cash rates at effectively zero for a longer and longer period, the price of gold has moved sideways to down. The price of gold is a perfect example of a market that simply reflects expectations, with no seemingly sensible valuation or economic rationalisations to get in the way it has to be levels of expectations, and their changes, that drive the price. This is why it is important to take a long term view of expectations for gold.

Ten and a half years ago, in a newsletter for The National Bank of New Zealand, I discussed the fact that a successful investor over the prior sixty years only had to make a handful of smart and bold investment decisions; own US shares from 1942 to 1966, commodities from 1967 through to 1980, Japanese shares for the decade of the eighties and then technology shares for the nineties. I concluded this section of the article with:

Financial assets generally have enjoyed massive price inflation over the last twenty years; it is therefore possible that once again real assets may start outperforming the still widely embraced financial assets.

I went on to raise some possibilities as to what might work in the decade ahead:

Commodities and precious metals have been amongst the most depressed assets since their bubble burst in 1980 and have long ago slipped off most serious investor’s radar screens. A marked change from twenty five years ago when they formed a part of any balanced portfolio. Prices in real, inflation adjusted terms for most commodities have plunged over the last twenty years even as demand for many of these products has grown. Eventually increased demand for any product in the absence of growing supply should result in price increases. With a growing world population, and a decreased focus on financial assets, resources and commodities generally may be the “previously depressed” asset that is next set to grow in price.

This assessment was largely based upon the fact that at the time no one wanted to invest in ‘real assets’ and gold in particular was seen as anything but precious. I pointed this out with this closing remark:

Most central banks around the world have been reducing their holdings of gold as reserves, this has undoubtedly had a depressing effect upon gold’s already depressed price. The price of gold has been bouncing along a little above $250 for a few years now having fallen from its high of $850 in 1980 and from an investors perspective has been largely unloved. It is interesting that over the last few months the price has begun to pick up at the same time as the world’s two fastest growing economies, Russia and China, have been buying gold for their reserves. The primary reason for their purchases has been their desire for diversification away from the very extended US dollar.

That was over a decade ago, how things have changed since. The dollar is anything but extended (on the upside) now and everyone it seems ‘knows’ the seemingly sensible reasons to own gold. This was highlighted in a recent CNBC article

"I think gold is going to go up against all currencies…central banks around the world are being too loose," Schiff said, arguing that the Dollar Index (Exchange:.DXY) "is going to be cut in half at a minimum. If we don’t change our policies, the dollar index could go much lower." On Wednesday, gold sank to a seven week low near $1,700 an ounce, only weeks after setting an 11-month high just shy of $1,800. "One day we’re going to look back at $1,700 with nostalgia," Schiff said. "People are going to be shocked at how inexpensive gold was when it could be snapped up for such a bargain price." (Emphasis added).

I think we can look back to the early 2000’s and be shocked at how ‘inexpensive’ gold was then, at least compared to current prices, but I believe it is more likely that gold is far closer to a peak than a trough and last year’s high may turn out to have been that peak. Certainly it has spawned an enormous industry in gold investment vehicles that barely existed ten years ago and is now spawning extravagant book titles.

A Wall Street Journal blog on 24^th October was headlined:

Gold: Do We Hear ’36,000′?

The blog went on to describe a soon to be released book;$10,000 Gold: Why Gold’s Inevitable Rise Is the Investor’s Safe Haven, by Canadian gold manager Nick Barisheff. The book forecasts that gold will hit $10,000 ‘before too long’.

The blog then went on to point out that similar extravagant claims have been made for other asset classes in the not too distant past.

“The resemblance may be purely coincidental, but the advance publicity for the book reminds us of what happened back in 1999, when a series of popular books forecasting sky-high stock prices came out one after another.”

The authors and publishers vied to outdo each other’s titles like drunken sophomores at a college football game yelling “We’re No. 1!” and “No, we are!” The low bid was Dow 36,000 by Kevin A. Hassett and James K. Glassman. Then there was David Elias’ Dow 40,000. Finally came Charles W. Kadlec’s Dow 100,000.

If history were to echo perhaps we have to wait for books proclaiming $50,000 or even $100,000 gold before calling a peak but perhaps such excess won’t take too long, in the equity market those titles came out in rapid succession towards the end of 1999. When Dow 36,000 came out in October 1999 it was forecasting that a market that had already quadrupled over the prior decade was going to quadruple again. Gold $10,000 is forecasting that a market that has risen six fold over the last decade is going to rise another six fold. Obviously anything could happen, but extravagant book titles tend to come out because they will sell, and what sells tends to reflect a comfortable consensus. They therefore reflect expectations that are already in the market. This certainly was the case with Dow 36,000.

In Dow 36,000 James Glassman and Kevin Hassett recommended that all investors should have 80% of their investment assets in the equity market and it seems Glassman followed his own advice and in his own words his 80/20 portfolio got ‘hammered’. Chastened by this experience earlier last year Glassman released ‘Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence’. In Safety Net Glassman is recommending a far more cautious and balanced approach, a 50% equities and 50% bond portfolio, not quite but close to the opposite end of the spectrum to where he was twelve years ago. Clearly Safety Net would have been a brilliant book to publish in late 1999, its advice would have been timely and extremely valuable to anyone that read it and would have ensured that so much of the pain that has been suffered over the intervening twelve years would have been avoided. But Safety Net would never have been published in those heady days of the late nineties, when everyone was going to be rich, because no one wanted to hear such a down beat outlook. What the public wanted, and so were given, were new racy high tech internet funds and books on how the sky was the limit. That was where expectations were then, and with such lofty expectations it is now obvious that disappointment was inevitable.

Now it seems, after twelve years of investment purgatory, expectations have travelled some distance back along the long term optimism / pessimism scale. Eventually, when the current secular bear market ends, ‘Never Again’ will be published, ‘why investment is the last thing anyone should do with their hard earned savings’ and maybe even Mr Glassman will oblige, and it will reflect expectations that have travelled all the way to the opposite extreme of Dow 36,000. We are not there yet, however, the fact that long term expectations have moved as far as they have is encouraging, at least from a very long term perspective.

In the meantime it should be enough to learn to avoid whatever books are hitting the best seller lists with extravagant forecasts, whether it is how to get rich in property, internet stocks or gold. These forecasts are far more a reflection of what has already worked, and a reflection of where collective expectations already are, than where future returns will be found.

To his credit Glassman has outlined why he was wrong about Dow 36,000:

“The world has changed since 1999. U.S. economic standing is now declining, and we have to account for risks not only to commerce but to the global order. In theory, historical averages show that stocks are a good buy if you can hang on through the miserable periods. But most investors find that excruciatingly difficult to do—a fact that I never fully appreciated in my 30 years of writing about investing. Fear, or simply a need for cash, triumphs, and people sell before stocks bounce back. I’ve gotten tired of telling investors to buckle up and hang on. Instead, I am urging them to adopt a more cautious strategy than the conventional financial wisdom—or "Dow 36,000"—would dictate.”

Expectations and emotions, or aggregate mood, are what drive markets over multiple time frames, not valuations and not economics.

Confidence

Consumer confidence numbers are one of the myriad of indicators that economists attempt to forecast, the thinking being that rising or falling results in these confidence surveys will give some guidance as to what the economy will do. On the back of that supposed ‘heads up’ on what the economy will do investors build investment strategies. The important question this raises is does confidence lead the market, and the answer unfortunately is that it does not; in fact given the delays in getting the results of these surveys out it actually lags the market a little. The results of confidence surveys do tell investors where markets are, that is whether they are rising or falling or in a bull or bear market, but that isn’t very valuable really as the market already provides the answer to that question!

A little over three years ago I wrote a Thoughts and Observations piece titled ‘Consumer Confidence – Cause or Effect?’ In it I wrote:

As well as the long term (secular) swings in valuation and confidence coinciding it is interesting to note that so too do many of the shorter term (cyclical) swings. This was particularly obvious during the long broad consolidation that the market went through from the mid 1960’s through to the early eighties. Each subsequent low point in the market occurred on sequentially lower confidence levels and at lower valuations; a similar pattern was seen at each successive peak. The important point is not that the market is driving consumer confidence or vice versa, rather that they both, virtually simultaneously, reflect a broader deep seated optimism or pessimism. Looking for changes in consumer confidence to provide some hint as to what markets might do is probably futile, just as believing that movements in the market affect confidence, they don’t. Both are driven by and reflective of basic levels of social mood, and its swings from pessimism to euphoria and back.

This can clearly be seen in the chart of US consumer confidence. Since the secular bear market began Consumer Confidence has tracked the market, it certainly has not led the market. The long term, secular peak, in consumer confidence was recorded in February and again in June 2000, at about the same level as was seen at the onset of the prior secular bear market in the mid 1960’s. Confidence then fell through to April 2003 and bottomed, the market had bottomed several months earlier. Confidence then rose throughout the cyclical bull market finally peaking at a lower peak than the prior peak, in August 2007. It then collapsed, coincident with the market, to a record low level and eventually bottomed in March 2009, exactly when not only the US but virtually every market in the world bottomed. Confidence then rose from that depressed level and finally peaked in March 2011, around the time most world markets recorded their last cyclical peak.

The same pattern of confidence tracking the ebb and flow of cyclical bull and bear markets was seen through the last secular bear market from 1966 to 1982 and it is interesting to note that just as the price low for the market was seen at the depths of the 1974 cyclical bear market, not at the end of the secular bear market in 1982, so too was the confidence trough. Whilst cyclical peaks throughout that secular bear market were more or less at similar levels that was not the case in the confidence survey, each subsequent peak in confidence coincided with a cyclical peak in the market but at sequentially lower levels. The same pattern has been seen over the last twelve years. This means that the depths of the lows seen in confidence in early 2003 need not be revisited but it is equally unlikely that the highs of 2007 and 2000 will be seen until long after the current secular bear market ends.

Whilst consumer confidence may not tell us any more than ‘where we are’ there is one confidence survey that seems to give some insight as to ‘where things are going’, and that is the survey of the confidence of corporate chief executive officers.

What follows is the latest result of the CEO confidence survey from the Conference Board.

CEO Confidence Declines Again

04 Oct. 2012

The Conference Board Measure of CEO Confidence™, which fell in the second quarter, declined again in the third quarter. The Measure now reads 42, down from 47 in the previous quarter (a reading of more than 50 points reflects more positive than negative responses).

Says Lynn Franco, Director of Economic Indicators at The Conference Board: “This latest report reflects ongoing concern about the strength of the economy. CEOs’ assessment of current conditions remains weak and they have grown increasingly pessimistic about the short-term outlook. Sluggish growth and a persistent cloud of uncertainty have played a role in CEOs curtailing spending plans this year.”

CEOs’ assessment of current economic conditions has grown more pessimistic, with just 9 percent stating conditions have improved compared to six months ago, down from 17 percent last quarter. Chief executives are also more negative in assessing their own industries. Now, just 14 percent of business leaders say conditions have improved, compared with 22 percent in the second quarter.

CEOs’ optimism about the short-term outlook has also declined. Currently, less than 12 percent of business leaders expect economic conditions to improve over the next six months, down from 20 percent last quarter. Expectations for their own industries are also more pessimistic, with just 15 percent of CEOs anticipating an improvement in conditions in the months ahead, down from 25 percent in the second quarter.  

Clearly this outlook is materially bleaker than that of consumers and it has already been deteriorating for some time. Worryingly this is a remarkably similar picture to that evidenced by CEO confidence surveys in late 2007 and into early 2008. This was an excerpt from the Conference Board’s release in January 2008:

Business leaders’ confidence in the U.S. economy has dipped to the lowest level since late 2000.

The Conference Board Measure of CEO Confidence, which had declined to 44 in the third quarter of 2007, fell to 39 in the fourth quarter. The last time the measure fell below 40 was in the fourth quarter of 2000, when it dropped to 31. (A reading of more than 50 points reflects more positive than negative responses.)

Unfortunately little comfort should be taken from the relatively elevated levels of consumer confidence in the US; all it tells us is that the market should be close to its recovery high, which until a few weeks ago it was. The fact that CEO confidence has continued to decline, in a similar manner to the slide seen ahead of the GFC associated bear market, is of far greater concern.

Commodities

I have referred to economist A. Gary Shilling many times over the last couple of years and in particular I recommended his book ‘The Age of Deleveraging’. He recently made clear his outlook for commodities in no uncertain terms in one of John Mauldin’s ‘Outside the Box’ pieces:

“The weakness in commodity prices, starting in early 2011, no doubt has been anticipating both a hard landing in China and a global recession. In my view, the foundation of the decade-long commodity bubble is crumbling, and the unfolding of a hard landing in China and worldwide recession will depress commodity prices considerably, even from current levels, as disillusionment replaces investor enthusiasm.”

I have shared his views on commodities, albeit perhaps less stridently, for many months. In April of this year I wrote:

No changes were made to our outlook on currencies. We continue to view the low seen last year in the US dollar as potentially a long term bottom and that surprises going forward are more likely to be on the upside for the US currency. In commodities we anticipate further downside and see last year’s peak in the CRB index as an important cyclical peak.

The weakness in the CRB is particularly notable given the strength in oil and raises some questions as to the durability of oil’s bull market.

Since then oil has fallen by about 25% and commodities indices have moved on balance sideways and rolled over recently. This leaves the peak seen in April of last year as the high for many commodities, just as it was for many stock markets around the world, as I discussed last month, and it raises the question whether the widely feared central bank induced inflation is as big a threat as so many currently believe.  

Last week CNBC ran the following story;

Fed’s Lacker: Latest Stimulus Will Boost Inflation Friday, 26 Oct 2012

 

Over the last four years the inflation versus deflation debate has swung from one extreme to another several times and each time the fear of one or the other grew to such a crescendo that major headlines were being made. The fear proved to be misplaced and gradually a fear of the opposite outcome grew.

Even after markets rolled over in late 2007 and into 2008 the major fear was inflation:

Inflation fears and oil prices pinch markets, June 11, 2008 New York Times

 

Soaring corn price fuels food inflation fears, June 11, 2008 Times Online

 

But as markets continued to collapse that fear receded and the fear of outright deflation emerged:

First inflation, now it’s deflation fears, Nov 11, 2008 Reuters

JUST four months ago, soaring commodity costs were the biggest economic worry as the oil price raced to a record high. Now the buzzword is deflation, which is altering both the economic outlook and the way governments need to respond to the threat of a deep recession.

This reversal was seen in just a handful of months. Finally as markets bottomed and began to rally gradually the deflation fear fell away only to be replaced by the threat of inflation again:

IMF Warns on Inflation, Growth Risks, Feb 6,2011 WSJ

 

Inflation leaps to 8-month high, pressure on Bank, Jan 18, 2011 Reuters

 

Inflation rise sparks fears of long-term spike, Jan 17, 2011 The Australian

 

Bond Market Flashes Inflation Warning, Feb 7 2011 WSJ

Jump in U.S. Treasury yields signals market fear that Fed is behind the curve on prices

How to Profit From Inflation, Feb 5, 2011 WSJ WEEKEND INVESTOR

The Scourge of Rising Prices Hasn’t Hit Home Yet, but the Underlying Signs Point to Trouble Ahead. Here’s What You Should Do Now

These fears have continued to grow and the fear behind them has only been stoked by the same ‘QE to infinity’ that is inspiring the many gold bulls discussed earlier. Throughout this secular bear market, that is nearly thirteen years old now, I have consistently believed that deflation was a far bigger threat than the kind of inflation that so many of us lived through in the seventies and early eighties when gold had its last great bull market and blow off, this continues to be my view. It is worth repeating a comment that the octogenarian market commentator Richard Russell wrote during the spike in inflation fears four years ago:

In the investment business, it pays to be suspicious of the obvious. If it’s obvious, every dim-wit knows about it, and it seldom pays to follow what every dim-wit knows and is operating on. 

Example – Everybody know that inflation lies ahead. Again, be suspicious of what everybody knows. 

This is very sage advice, and not only about the prospects for inflation, it gets to the heart of what I have consistently maintained drives markets; expectations. It is when hopes are dashed and fears prove baseless that markets reverse, not when the news goes from good to bad or vice versa.

I said don’t believe in the Music Man!

One ‘expectation’ that I have been very dubious about has been that central banks can and will do ‘whatever it takes’.

Two months ago in the September edition of Strategy Thoughts I discussed at some length the concern I had that investors seemed to have absolute faith in the power of central bankers to prevent an investment market catastrophe. I was astounded that this faith was so strong despite the Global Financial Crisis, the worst economic and investment market collapse in seven decades, being less than a handful of years ago. I suppose one might try to argue that things would have been worse if not for central bankers but it seemed three months ago, and continues to now, that investors’ expectations over central bankers’ ‘power’ are far too optimistic. Last month Dallas Fed chairman Richard Fisher, who has been outspokenly critical of the ‘Bernanke doctrine’ commented in a speech:

 “It will come as no surprise to those who know me that I did not argue in favour of additional monetary accommodation during our meetings last week”.

“I have repeatedly made it clear, in internal Federal Open Market Committee deliberations and in public speeches, that I believe that with each program we undertake to venture further in that direction, we are sailing into uncharted waters. We are blessed at the Fed with sophisticated econometric models and superb analysts. We can easily conjure plausible stories as to what we will do when it comes to our next tack of eventually reversing course.”

“The truth, however, is that nobody on the committee, nor on our staffs at the board of governors and the 12 banks, really knows what is holding back the economy. Nobody really knows what will work to get the economy back on course.”

“And nobody –in fact no central bank anywhere on the planet – has the experience of successfully navigating a return home from the place in which we now find ourselves.”

“No central bank –not least the Federal Reserve – has ever been on this cruise before.”

As the slide down the ‘slope of hope’ continues this blind faith, or hope, will gradually, and at times rapidly, evaporate and be dashed. When the next cyclical, and possibly secular, buying opportunity arrives central bankers will likely be despised for the terrible job they have done rather than celebrated as being able to do ‘whatever it takes’.

Conclusions

Overall my views on most asset classes and markets have not changed since early last year. It was then that most equity markets rolled over and began sliding down their next cyclical bear market, their next slope of hope. Very few markets have rallied to higher highs on this most recent rally but the widely followed US market obviously has. Nonetheless I continue to believe that a cyclical bear market globally is continuing to unfold and that preservation of capital continues to be more important than chasing returns or yield, particularly in what is likely to continue to be an environment more characterised by deflation than inflation.

None of these conclusions are arrived at as a result of my economic outlook, I don’t start out with such an outlook, but obviously if my scenario for investment markets eventuates it is likely that more challenging times lie ahead rather than the continued, albeit weak, recovery that so many hope for. Markets are driven by people, their hopes and fears and expectations, and as such reflect aggregate social mood. The beauty of markets is that they reflect this virtually instantly, in real time. The same cannot be said either of confidence surveys or economic numbers, both of which suffer from substantial lags.

Final Comment

It has been commented that many of my remarks tend to be quite US centric, this is a fair observation but not one that I currently take as a criticism. The world does still look primarily to the US for leadership, and not just in the area of financial markets. This reliance upon the US for a lead on what may happen next, at least in the area of markets, was brought home today by the frequent comments on the TV and radio to the effect that with the US markets closed due to Hurricane Sandy it was difficult to know what other markets would do. It will certainly be interesting to see just what happens when markets open once more on Wednesday US time.

Kevin Armstrong

30^th October 2012

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