Kevin Armstrong’s Strategy Thoughts

October 2012

Can all the news be good for the market, whatever it is?

Introduction

The most frequent feedback I have received over the last couple of months has been that markets have continued to rally, much to the frustration of the bears. However, it is worth digging below the surface of this observation. To do this one has to look at the ‘breadth’ of the current global equity market rally and the internal breadth of each market; that is the number of markets and stocks rising versus those falling and what the average stock has done. In this month’s Strategy Thoughts I revisit the ‘San Juan Hill Theory’.

Over the years I have on occasion referred to the ‘San Juan Hill Theory’ and it has been a helpful tool in identifying cyclical peaks within the currently still unfolding, and far from over, secular bear market. I say far from over secular bear market purely from a perspective of valuation, and it is only over secular time periods that valuation is of any use to investors. The current secular bear market may be more than twelve years old but, apart from a handful of very depressed European markets, most major equity markets are a very long way from being historically ‘long term’ cheap. Long term cheapness I have previously illustrated employing Tobin Q valuations, cyclically adjusted P/E ratios and dividend yields and none of these measures have approached the kind of historical extremes found at secular troughs.

In addition to the poor breadth found in most markets, and the disappointing experience the majority of investors would have had despite the headlines focusing on rising indices, there are a number of other issues that should be encouraging a cautious outlook. One is the current obsession that all news somehow is good news, another is the action of commodities (oil in particular), and a third is the recent weakness in transportation stocks and rails in particular. All of these will be explored in this month’s Strategy Thoughts, but first I want to examine the danger of finding comfort in an apparently rational anticipation of future market movements.

It may make sense, but it probably won’t work!

Last month my wife and I were in Melbourne meeting with the publisher of ‘Bulls, Birdies, Bogeys and Bears’, while there a number of former colleagues kindly took us out to dinner and gave me a couple of books they thought I would enjoy. Their choices could not have been better; one was on golf in Australia while, more importantly, the other was on trading and risk taking in markets; ‘The Hour Between Dog and Wolf’. This is an outstanding book that I cannot recommend strongly enough to anyone who is interested in what truly drives markets. Long term readers will know of my fascination with and passion for a behavioural rather than economic approach to markets and investing, well this book goes even further. The author, John Coates, a senior research fellow in neuroscience and finance at Cambridge University and a former trader with Goldman Sachs, explores the effects that biology and neuroscience have upon our decision making, why seemingly sensible and logical approaches can so often fail and what it is that truly successful traders have and do, without conscious effort, which makes them successful.

One section mid way through the book brilliantly highlighted the seemingly sensible and comfortable ‘traps’ that most investors and traders fall into. Chapter four is titled ‘Gut Feelings’ with a section on ‘feeling the market’. Coates wrote;

“While trading on Wall Street, I often conceived trades that I thought were brilliant, identifying some securities that were cheap, others that were expensive. But my boss, habitually sceptical, would always ask, ‘if the trade is so compelling and the money making opportunity so amazing, why hpeople spotted the trade? Why is the price discrepancy just sitting there on the screens for all to see, like a $20 bill lying on the sidewalk?’ These were irritating questions, but in time I recognised their wisdom. For more often than not, trades conceived with obvious lines of reasoning turned out to lose money. It was a troubling discovery. Troubling because these trade ideas were usually arrived at using my best analytical efforts, drawing on my education and a wide reading of economic reports and statistics. I was acting as rational economic man. In time, though, I realised I needed more than these cognitive operations. Often, while looking at a problem face on and coming to some obvious solution I would catch a glimpse with peripheral vision of another possibility, another path into the future. It showed up as a mere blip in my consciousness, a momentary tug on my attention, but it was a flash of insight coupled with a gut feeling that gave it the imprimatur of the highly probable.’

I have always maintained that successful investing is more of an art than a science and that attempting to forecast markets by building an economic outlook is futile. Even if your economic outlook is absolutely correct it is unlikely that the correct investment conclusions will be arrived at. It is also the case that whatever economic outcome appears most likely and even obvious then, as Coates describes, that outcome is already priced into the market. But still most investors and strategists preface their investment view on an economic scenario that they believe is most likely, this approach undoubtedly builds comfort, and the more people that share a similar view the more comfort grows, but unfortunately that comfort is totally misplaced.

Currently there is a worryingly strong consensus as to what any economic outcome might mean. Incredibly it seems that it virtually doesn’t matter what happens, bad economic news and good economic news will both prove positives for investors!

Is bad news really good news?

With markets rallying after the ECB announced a potentially unlimited appetite for distressed countries’ bonds and the US Federal Reserve’s announcement of QE3, or what some have labelled QE infinity it is apparent just what conventional wisdom has become. Good news, and especially surprisingly good news, will cause markets to rise, but so too will bad news, especially really disappointing news, the perverse logic being that such terrible news would cause central banks to do more of ‘whatever it takes’. This ‘logic’ was expanded upon as markets rose on the back of some bad news in early September. Bloomberg reported:

U.S. Stocks Rise Amid Stimulus Bets After Employment Data

By Lu Wang and Rita Nazareth - Sep 8, 2012

The article began:

U.S. stocks rose, sending the Standard & Poor’s 500 Index to its highest level in more than four years, amid bets on central bank stimulus as American payrolls increased less than projected.

It then supported this contention with input from investment managers;

“The market is taking this weak jobs number as a positive because it means that we’re going to get action coming from Bernanke and company,” said Michael Mullaney, who helps manage $9.5 billion as chief investment officer at Fiduciary Trust in Boston. He spoke in a telephone interview, “It’s just this new upside-down world of investing that we’re living in where bad news is good news for assets.”

It certainly would be an ‘upside down world’ where the only thing markets could do was rise, irrespective of what was happening. Whilst it is understandable that such an outcome would be popular it does not mean that it is in anyway a correct or even useful assessment. Rather what it does highlight is that investor attitudes and sentiment have become incredibly one-sided. They may not own up to being so, but when only one outcome appears possible it is likely that a surprise may lie around the corner, that was what occurred the last time that bad news was seen as good news because of the central bank action it would induce.

Almost exactly four years ago the Market Oracle website ran the following headline;

The article began with:

“Since the Fed interest rate cut in September, the stock markets across much of the world took the cue to let rip with strong bullish rallies. The trigger for the rally is a switch in market perceptions from interest rate rises to interest rate cuts. The market is therefore pricing in more interest rate cuts AND lower inflation.”

Obviously the story was slightly different back then, but what those who see any news as good news now must hope is that the outcome is very different.

As can be seen from the headline, the article appeared on the 7^th October 2007, just four days later the great bull market from 2002 ended and the market collapse associated with the GFC began, the worst bear market since the nineteen thirties. Those bullish investors were cruelly and rapidly disabused of any idea that bad news was good news. Interestingly a year and a half later attitudes had gone through a one hundred and eighty degree swing so that then, in March of 2009, bad news was bad news and good news, no matter how good, was not good enough to make anyone think the market could rise!

Not all commentators were so blinkered as to argue that bad is good and good is good. I strongly recommended to readers A Gary Shilling’s ‘The Age of Deleveraging’ last year. It was a hefty tomb but made a very clear case for deflation risk rather than inflation risk and also for incredibly low government bond yields. I have followed Shilling’s writings for more than a decade now, since reading his earlier book simply titled ‘Deflation’, and believe his observations and analysis to be refreshing, different and unlike most economic analysis, useful. Richard Russell in his Dow Theory Letter in mid September, amid all the bad news is good news commentary, quoted Shilling:

"Well, I beg to differ with the ‘It’s so bad, it’s good’ crowd. Conditions are so bad, they’re bad. All the immense monetary and fiscal stimuli here and abroad in the last five years have failed to offset the gigantic deleveraging in global private sectors. And they’re unlikely to do so until global deleveraging is completed in another five to seven years." A Gary Shilling

A similar attitude was adopted by Nouriel Roubini:

Investor euphoria as Federal Reserve launches QE3 risks turning sour

Financial markets that rise on both good and bad news are not stable

Nouriel Roubini The Guardian 14^th September

Roubini wrote:

“So, not only has good – or better than expected – economic news boosted markets, but even bad news has been good news, because it increases the probability that central banking firefighters like US Federal Reserve chairman Ben Bernanke and European Central bank president Mario Draghi will douse the markets with buckets of cash. But markets that rise on both good and bad news are not stable markets.”

The complacency that all news is somehow good continues to be shown in the still very low readings on the CBOE volatility index, the VIX:

Low readings on the VIX, such as those at present, have always eventually been followed by higher, and occasionally much higher readings and the journey from low to high readings have tended to be very uncomfortable for those investors that previously had only expected even higher prices ahead.

Naturally none of this commentary can pin point when a reversal will occur, however, it does highlight that the risks of such a reversal have only continued to increase the more the market has risen.

A lot of the comments above were referencing the US market, which has been making new recovery highs over recent months, however, this US strength, which has captured headlines, has masked what is still only a bear market rally in the majority of markets around the world.

Breadth

Over the years I have occasionally referred to an early warning system for the onset of a bear market that I first read about more than thirteen years ago in ‘The Bear Book’ by John Rothchild. In it he described the ‘San Juan Hill Theory’;

“Hong Kong pundit Marc Faber says stocks reach the top when the generals (large stocks) are charging up the hill while the troops (small stocks) lag behind. It is not uncommon, says Faber, for the generals to plant the flag nine months after the troops have retreated.”

Over the last couple of cyclical bull market peaks I have extended this analogy of the ‘generals’. Rather than just focusing upon the largest companies in an individual market it has also proved of value to study the breadth of the global market. Prior to both the 2007 peak and the peak in 2011 a deterioration in global breadth was apparent, this continues to be the case despite the much heralded recovery highs recorded by the major US indices.

Within the US most indices have recorded higher highs than those seen in 2011; however, the transportation index is still down 10% from its mid 2011 high. Europe as a whole is still 15% below its early 2011 high with Finland and Austria both down about 30%, France and Russia about 20%, Hungary down 25% since its 2010 high, Spain, despite a recent 30% bounce, still down 37% since the beginning of 2010 and Greece, perhaps understandably down nearly 75% from its 2002 high. Within Europe Germany is virtually flat with its 2011 peak and only a handful of markets including Denmark, Norway and Ireland have recorded new recovery highs above their 2011 peaks. Overall the breadth of this rally in Europe continues to more closely resemble a bear market rally rather than an extension of the cyclical bull market that began at the very depressed lows of early 2009.

The same picture is found across the Asian markets. The Chinese market is 40% below its 2010 recovery high, Hong Kong remains 17% below its late 2010 high, Korea is still 11% below its 2011 peak and India, Australia and Singapore are all 7-11% below their 2010 levels, Vietnam is down 39% since late 2009 and Sri Lanka is 25% below its early 2011 levels. Only the Philippines, Pakistan, Thailand, Indonesia, Malaysia and New Zealand have rallied to new recovery highs along with most of the US indices, overall the MSCI Asia index is still 10% below its April 2011 level.

The weakness of this recent rally on a global basis can be seen in the chart below of the Global Dow Index, it also highlights the divergence that has been seen between the US market and the experience of most other markets in the world. The most recent peak was below the peak recorded earlier this year and, more importantly, almost 15% below the peak seen in the first half of 2011. It is also below the two peaks seen in early 2010 when a number of the markets listed above rolled over. It is therefore not surprising that equity markets have been frustrating for  more than two years now, however, just because they have been frustrating is no reason to buy into the ‘hope’ that is now so prevalent.

The ‘hope’ that central banks will do ‘whatever it takes’ to fix the current long term problems is not just evident in equity markets, it has also become clear in credit markets. The cost of protecting against default on the part of European governments has shrunk dramatically over recent months, as equity markets have rallied. In Spain the cost of such protection has fallen back to where it was in the early months of this year, in Italy the same measure is now below that level, both have fallen more than 30%. Other European countries have seen the cost of default protection fall even further, in many cases back to levels not seen since early 2011.

The rally has obviously offered opportunities to successful traders; however, for investors there has clearly been less to get excited about. It is also a concern that there may now be less for anyone to get excited about, let alone build ‘hope’ upon.

Is that all there is?

Back in late July Mario Draghi, President of the European Central Bank, made his now famous speech announcing that they would do ‘whatever it takes’ to save the Euro. On the back of that European markets rallied sharply, the Euro Stoxx 50 index surged almost 10% over the next three days but now , two months further on, has only managed to rise another 8% having faltered over the last few weeks at a lower levels than were seen in March of this year. With the market now knowing that the ECB will do ‘whatever it takes’ it is getting hard to see where the next positive surprise can potentially come from, irrespective of whether or not you believe they can do ‘whatever it takes’.

The same observation can be made about the news that came out of the US Federal Reserve in mid September. It was hoped that another round of quantitative easing would be announced, the so called QEIII, after the prior rounds of QEII and QEI. What was announced was almost a ‘whatever it takes’ and understandably it has become known as QE Infinity! When you have announced a totally open ended round of quantitative easing it is hard to see where the next big positive surprise comes from. As was the experience in Europe there was an initial surge on the back of the news, the Dow jumped 200 points the day of the announcement and another 100 the next day before giving up half of that day’s gains to close only 50 points higher. Over the subsequent three weeks the US market has moved broadly sideways and European markets have slipped a little. Perhaps there are still further positive surprises to further fuel hope in this rally but my concern is that we have indeed seen ‘all there is’ and that the faltering seen since the announcements, and the longer term deterioration in global breadth, are both indicative of an ageing and deteriorating rally in those markets that have eked out modest gains compared to earlier peaks and a resumption of the cyclical bear market, and slide down the ‘slope of hope’ in the rest of the world.    

A secular turn?

Frequently in the past I have questioned the certainty that the majority of economists have displayed in arguing that long term yields in the US had to rise. The more vociferous their cries the more certain I was that the surprises would be on the downside, but then in August attitudes appeared to shift.

In the August edition of Strategy Thoughts I wrote:

For a very long time I have proclaimed the virtues of long dated US treasury bonds, and anticipated that yields would go lower than virtually any economist was forecasting. I also didn’t expect long dated yields to rise until the consensus view had given up on looking for higher rates and accepted low rates for a very long time. In June I wrote;

“Until the fear of deflation and ever lower yields becomes widely embraced and discussed it is likely that further surprises on the downside in yields, not a sudden reversal to the upside, are in prospect.”

At the time ten year treasuries were yielding a little over 1.7%, over the next eight weeks yields plunged, briefly falling below 1.4%. As a result there has been an interesting shift in investor expectations and attitude. Two days ago Bloomberg ran the following story;

Treasury Bears Submit To Fed As Bond Optimism At High

 

Jay Mueller, who manages $3 billion of bonds for Wells Capital Management in Milwaukee, resisted buying Treasuries for four months, anticipating the Federal Reserve would drop its pledge to keep interest rate at a record low through late 2014. No more. With the economy growing at a 1.5 percent annual pace, the odds of a recession have risen to 60 percent, making 1 percent yields on 10-year notes a possibility, he said. Wells Capital’s parent, Wells Fargo & Co., boosted its Treasury holdings 32 percent to $11.5 billion in May alone, according to the latest data compiled by Bloomberg. “We’re in a low-rate environment for a long time, longer than I had thought,” Mueller said in a July 26 interview at Bloomberg headquarters in New York. “I’m finally throwing in the towel.” So are Pioneer Investment Management Inc., Pacific Investment Management Co., Federated Investors Inc., Northern Trust Global Investments and Columbia Management Investment Advisers LLC. They are adding to holdings of Treasuries as economic growth cools. Of the 20 firms that own the most Treasuries, 16 bought more U.S. government debt during their most-recent reporting periods, Bloomberg data show.

If treasury yields continue to rise, as they have over the last three weeks, and spreads start to widen junk bond returns will start to struggle.

Since then the pursuit of yield has continued at a frenetic pace. Towards the end of September the Wall Street Journal reported that yields on US corporate bonds hit a record low;

“Corporate-bond yields fell to another record low as recent moves by central banks continued to drive investors into riskier investments. That pushed down the interest, or yield, bond buyers could demand. The Barclays U.S. investment-grade index fell to 2.82% on Tuesday, down 0.09 percentage point from the start of the month. The record heading into 2012 was 3.36%, in data going back to 1973. Investors have piled into corporate bonds this year, seeking higher rates of return than those available from low-yielding Treasurys, while maintaining the relative safety of fixed-income securities.”

 

Of greater concern has been the flood of money that has poured into junk bond funds. According to the Wall Street Journal in September alone nearly $9 billion was invested in such funds in the pursuit of now record low yields on junk bonds. This brought the total for 2012 flowing into such funds to $64.5 billion, more than twice the previous annual record.

Whilst this chase for yield is understandable it is important to note what has been happening to the yields on longer dated Treasury bonds over the same period. Almost coincident with the attitudinal shift I commented upon two months ago ten year US Treasury bond yields have been gradually moving higher in a three steps up two steps back fashion. All this means that spreads between the yields on junk and Treasurys have continued to narrow, just like those credit default swaps on European Government bonds. If markets are in the process of rolling over then the currently popular junk bonds may deliver a nasty shock to yield hungry investors. But then history has repeatedly shown that whatever sector, or industry, sees the number of funds available and the assets invested surge upwards, a reversal is usually not far away.

I continue to be concerned about the prospects for bond investors chasing yield and believe that the chances of the low, seen in late July in ten year treasury yields, being an important long term secular low as very high.

Railroads

In The May edition of Strategy Thoughts last year I discussed the weakness that had been seen in the previously outperforming railroad stocks. I concluded that section with the following observation:

“from a shorter term perspective it is somewhat worrisome that the previously rampant railroad stocks have faltered over the last four weeks while the broader market averages have continued to rise.”

Thse comments were writen on April 26^th 2011, from that point railroads did recover, and so too did the market, however, that first crack in the railroads heralded a far more severe decline a few months later when the railroad index plunged thirty percent in just three months from early July, as can be seen in the chart below.

The Industrial Average held on for about another two weeks from that high level into late July and then fell close to twenty percent.

More recently the railroads have once again dramatically underperformed while the industrial average has clung on to its recovery highs. Since mid September the railroads have fallen more than ten percent, at the same time the industrial average is virtually unchanged.

This does not mean that, like fifteen months ago, the industrial average will follow the rails down, what it does highlight is the lack of ‘breadth’ in the market, highlighted in the introduction and the ‘San Juan Hill Theory’ should not encourage anyone to chase this ever narrowing rally.

Other thoughts on ‘breadth’, commodities and China

I have mentioned the Baltic Dry Freight Index a number of times in the past. It became one of the most watched indicators as the GFC was running its course, understandably given the absolute collapse that it suffered. What is intriguing now is how it continues to just bounce along at historically incredibly depressed levels. It did bounce back after the ‘Great Recession’ but that rally was short lived, only through to late 2009, early 2010, and then its bear market resumed. In many ways the chart is a remarkable ‘echo’ of the Chinese stock market, whose bear market rally only lasted through to August of 2009. In fact it is similar to many markets, excluding the US and a handful of others, that have failed to make any progress since their immediate post GFC rally.

I have shown the Baltic Dry Index on the top and the Shanghai Composite below. Whilst their peaks were not quite coincident their behaviours since the GFC related collapse have been remarkably similar, and neither show any signs of the ‘rally’ that has supposedly been in force since late June. In fact the cyclical bull market that began in just about everything and all markets in late 2008 to early 2009 barely lasted a year for these two indices. What has been suffered since early 2010 has been another meaningful cyclical bear market.

The final chart below shows the US market as measured by the Dow compared to the price of oil over the last two years. Over that period the oil price has been particularly volatile. It fell by 40% before rallying back close to its old highs, then fell by 30% before another less dramatic rally and then most recently it has suffered another 10% correction. What is most interesting to note is that over that period peaks in the price of oil have been a leading indicator for peaks in the market.

At the end of April last year oil peaked and fell precipitously, that sharp fall was to turn into a five month rout that saw oil prices drop nearly 40%. However, in the early stages of oil’s collapse the equity market totally ignored whatever was troubling oil. Broadly speaking the US equity market moved sideways for another two months before joining oil in its plunge. From mid July through to the October low the US equity market fell 20%, half of oil’s fall but still a meaningful and at the time most worrying decline. Both markets bottomed together in October and from there enjoyed a substantial rally through the end of the year and into 2012, but on the 1^st of March oil once again peaked and began an almost four month decline that saw its price fall by 30%. Again it seemed that equities had little concern over oil’s plunge, at least for a month, but in May equity markets began their worst correction since October of 2011, a 10% correction. More recently, and in another indication of the ‘breadth’ of the overall global rally deteriorating, oil suffered another setback falling, so far, 15% to its recent low. Whether this is the beginning of another significant plunge for oil only time will tell but again it is interesting that US equity markets are grimly hanging on at the same levels they held when oil began its latest fall.

Conclusion

I have commented many times over the last few months about just how frustrating the recent market action has been, and not just for those of a bearish disposition, bulls will have struggled too given the deteriorating global breadth that has been seen. It is also important to put the recent strength into a meaningful perspective and not measure it just from the lows at the end of June but over a longer period.

It does concern me that so many commentators are comfortable rationalising just why markets should continue to rise, particularly when those rationalisations seem to always involve a seemingly sensible interpretation of the ‘economic outlook’. Such approaches do build comfort but rarely deliver long term returns, and invariably the more comfortable an investor is the more concerned he should be.

Now is not the time to be chasing yields or returns. There will be some remarkable opportunities in the months and years ahead and it will be important to have preserved ones buying power ahead of such opportunities. However, it is also important to remember that when those opportunities do arrive they will not feel like opportunities. In fact it will take great discipline and intestinal fortitude to even consider looking at them let alone seize them, there will certainly not be any headlines proclaiming their virtues and no one will be producing seemingly sensibly rationalisations as to why the only way for anything is up.

Recommendation

I have now been dragged into the twenty first century and, over the last few weeks, have become somewhat addicted to listening to podcasts on my daily jog, I have now even learnt how to download them myself! This learning curve began when I heard a small part of Professor Niall Ferguson’s BBC Reith lectures; http://www.bbc.co.uk/podcasts/series/reith

This series of lectures provides a refreshing and different perspective upon what we have all been through over the last five years and provides some uncomfortable suggestions as to what should be done in the future.

Finally, for those of you interested in my book ‘Bulls, Birdies, Bogeys and Bears’, the text is complete and is now undergoing editing. From there design work begins and it is now looking like it will be released early next year. I will keep you posted.

Kevin Armstrong

5^th October 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

Last month I likened the recent relative calm evidenced in investment markets as being the ‘eye of a storm’ and questioned how much longer the relatively benign ‘eye’ would linger over markets that had been frustrating to both bulls and bears. Well, the ‘eye’, and the frustration, has continued for at least another month. At the same time volatility measures remain at historically low levels implying that ‘fear’ is not currently the prevalent emotion amongst investors.

In this month’s Strategy Thoughts I explore some of the attitudes that have emerged surrounding the presence, or lack, of fear in markets and the increasingly frequently heard term ‘tail risk’. I will also revisit a topic I have discussed on several occasions, the misplaced ‘hope’ that central bankers will fix things. The mere fact that this hope is still so present highlights that the longer term secular bear markets, in much of the developed world, still have some way to run.

Long time readers will know that I have little faith in market forecasts based upon economic forecasts (or perhaps extrapolations is a better description), markets have a far better record of forecasting the economy than the other way around and by the time changes in the economy are manifestly obvious in data those changes have already been reflected in markets. Nonetheless, an economic basis is the starting point that the majority cling to, each apparently hoping that not only will their economic prognosis be better than the majority’s but also that they will interpret what that prognosis may mean for markets correctly.

It is astounding that despite the manifestly obvious shortcomings of such an approach, through the tumult witnessed over the last twelve years, that still so many cling so firmly to it. It is like Pavlov’s famous dog, only food never comes when the bell rings but still they salivate in anticipation. These shortcomings have been explored in a couple of articles over the last month. It is also illustrative of this conditioned reflex that ‘expert’ forecasts of where the markets will end the year are almost all premised on some level of valuation based upon economic assumptions. As humans we all hate uncertainty, investing is obviously inherently uncertain and so we look for things to provide comfort amidst that uncertainty. Economic data and valuation levels can all be measured, and they can be particularly accurately measured retrospectively, unfortunately, neither are useful in forecasting market movements over time frames that the majority are interested in. That so many rely upon such measures over these time frames is understandable. The fact that so many do is what makes it feel so comfortable, we are after all herding animals, but that doesn’t mean it is the sensible or useful thing to do, no matter how comfortable it may feel.

‘Tail Risk’

During the great bull market of the eighties and nineties ‘tail risk’ was a term that was hardly discussed, back then diversification was seen as the answer for investors seeking protection from highly unlikely but potentially very damaging events. However, since the Global Financial Crisis (GFC) more and more investors are becoming aware that diversification doesn’t always deliver that protection; in times of severe crises correlations approach one, as they did in the second half of 2008. Discussion of the impact of tail risks has also been fuelled by the familiarity that most investors now have for ‘Black Swans’, a term originally coined for use in investment markets by Nassim Taleb and popularised in his hugely successful and remarkably prescient 2007 book, ‘The Black Swan’. Whilst all tail risks are not necessarily Black Swans it is probable that the effects of Black Swan events, that is hugely damaging (or hugely rewarding) but totally unforeseeable events, are eventually described as falling into the category of tail risks.

From a very long term (secular) perspective it is encouraging that attitudes have gone through something of a shift from those of the latter stages of the last secular bull market, it illustrates that some progress has been made through the current secular bear. Nonetheless, from a shorter term, cyclical, standpoint it is concerning that discussion of how large or small tail risks may be is growing.

Throughout the current secular bear market, that is from 2000 onwards, tail risks have been seen to be high at market troughs and low at market peaks. If one thinks about this for a while that is to be expected. The reason a market peaks is because the majority see little to be afraid of, as a result expectations become elevated setting up the preconditions for disappointment and so a decline in the markets. Similarly the reason markets bottom is because the majority are fearful that, despite things already being bad, they will likely get worse. This sets in place the potential for a positive surprise and so a rising, but disbelieved, market. Fear of tail risks or Black Swans is high at troughs and low at peaks.

This can be seen in the chart below:

The Chicago Board of Options Exchange who produce the VIX index, shown in the chart above overlaid on the S&P500, state that the VIX is a “key measure of market expectations of near term volatility conveyed by S&P500 stock index option prices.” Put another way, the VIX indicates market expectations of future stock price volatility, or risk. A high reading on the VIX implies expectations of risk are high and low readings that expectations of risk are low. What is obvious in the chart is that expectations of risk rise as the market falls, and fall as the market rises, with the result that it would appear to indicate that the market gets riskier the lower it gets and less risky the more it rises. This is obviously absurd. What does rise the more a market falls is the fear, on the part of investors, that things will get worse and what falls the more a market rises is that same previously misplaced fear.

Currently we hear that tail risk has fallen, this is highly unlikely, tail risks, like Black Swans, are always lurking in the background, unseen and unpredictable. What has fallen is investor fear of tail risks or Black Swans, just as it always does the more a market rises.

Two weeks ago, on the 17^th August, the VIX traded at its lowest level since June 2007. Then markets had been in a very rewarding cyclical bull market for more than four years and in the conclusion to the July 2007 edition of Strategy Thoughts, written in late June, I wrote;

“The future is unlikely to be a neat continuation of what has been enjoyed by so many for so long, it is likely to be more challenging.”

As indicated by the level of the VIX back then levels of fear were very low, as they are now, but the tail risks and Black Swans were all lurking in the background and they certainly came out with a vengeance over the subsequent eighteen months as the entire world witnessed. Currently investors continue to favour living in hope rather than having to cope with fear.

The Hope continues!

Two months ago, in the July edition of Strategy Thoughts, I titled one section, ‘The other great Hope! Central Banks?’ At the time the ‘hope’ was rampant that central bankers the world over would ‘fix’ whatever was ailing the financial world. I wrote;

Whilst it may be understandable that we humans cling to and seek hope, it is remarkable that we just don’t seem to learn, even from the relatively recent past. There remains an abiding hope that central bankers will fix whatever the problem is, that they will do ‘whatever it takes’. These are sentiments that are often reported and in some quarters relied upon, what is most surprising is that that the same phrases continue to get trotted out and that the faith in the ‘almighty’ central banker is so strong.

This ‘hope’ has persisted as the current bear market rally, within the broader slide down the ‘slope of hope’, has continued. Most recently there was an almost overwhelming sentiment of hopeful expectation, on the part of most of the financial media, ahead of Ben Bernanke’s Jackson Hole speech, with the prevalent ‘hope’ being that the next round of QE would be announced and so provide the next leg up in financial markets. The actual outcome seems to have been that ‘frustration’, as I discussed at length last month, continues.

It was with some relief that at the beginning of last month I read the following article in the Wall Street Journal. It did a far better, and more entertaining job of illustrating the futility of investors hanging onto every central banker’s pronouncement than I could ever have done

The Music Men: The illusion that central banks alone can conjure faster growth.

WSJ 1st August 2012

“As the financial world breathlessly awaits word this week from the Federal Reserve and European Central Bank, we can’t help but think of "The Music Man." In that classic if now dated musical, the residents of an Iowa town are gulled by a huckster selling band equipment. They desperately want to believe in his power to solve their town’s delinquency problems, until they discover Harold Hill can’t play a note. Central bankers are today’s music men, the maestros we desperately want to believe can rescue the world economy by playing one more monetary tune. Buy more bonds and lift the stock market! cry the boys at Pimco and Goldman. Pay less for bank reserves! shout the Princeton professors. Promise to keep rates at near-zero until 2015—or 2016 or 2017—beg the politicians. And so Mario Draghi and Ben Bernanke will try to sell us 76 more trombones. Sooner or later we’ll discover that their money illusion can’t save an economy from its more fundamental problems, and that they may even be interfering with the faster growth they want.”

The article went on to illustrate that successive actions on the part of the Federal Reserve have had less and less impact, irrespective of however much credit chairman Bernanke wants to take. A similar theme was picked up by John Mauldin in his weekly ‘Thoughts from the frontline’ this week when he extensively quoted from a recent paper by William R White, chairman of the Economic Development and Review Committee at the OECD, which was published on the Dallas Federal Reserve website.

The paper’s conclusion began with;

“The case for ultra easy monetary policies has been well enough made to convince the central banks of most AMEs to follow such polices. They have succeeded thus far in avoiding a collapse of both the global economy and the financial system that supports it. Nevertheless, it is argued in this paper, that the capacity of such policies to stimulate “strong, sustainable and balanced growth” in the global economy is limited. Moreover, ultra easy monetary policies have a wide variety of undesirable medium term effects - the unintended consequences.”

The paper went on to finish with the following warning;

“What central banks have done is to buy time to allow governments to follow the policies that are more likely to lead to a resumption of “strong, sustainable and balanced” global growth. If governments do not use this time wisely, then the ongoing economic and financial crisis can only worsen as the unintended consequences of current monetary policies increasingly materialize.” 

But for investors it is easier, and more comfortable, to belief that things can somehow painlessly revert to ‘normal’ at the hands of central bankers. Or at least what the majority, who have spent most of their investing careers enjoying the wonderfully rewarding and benign backdrop of rising equity markets throughout most of the eighties and nineties, believe to be normal. It is easier and more comfortable to believe that somehow the tech wreck and the GFC were the anomalies rather than the natural consequence, or price that has to be paid, after a wonderful ‘secular’ (very long term) almost two decade long bull market ends, as it did in 2000.

It’s the economy stupid, or is it?

As noted above, most investors seek to rationalise investment decisions based upon some economic outlook. This does at first blush appear a sensible approach, it at least provides some foundation even if, as already commented, the records of economic forecasters are questionable and the interpretations of what even correct forecasts will mean to markets is open to just as broad an error. It is not only me that is frustrated with the efforts of economists; the following headline appeared in the Guardian on the 6^th June this year;

Why do we take economists so seriously?

They have no foresight, no hindsight, and little humanity. Are they really the best people to lead us out of this crisis?

They do provide comfort however, that there is some explanation as to why something happened, even if their crystal balls don’t work.

The fact that the straw of economic forecasting should not be clung to by investors was beautifully illustrated by Gerard Minack of Morgan Stanley Australia recently. In a piece titled ‘Mind the Gap’ he summarised the lack of connection between economic growth and stock market performance.

High-trend GDP growth still underpins some investors’ focus on EM equities. However, there’s no correlation – even over very long periods – between GDP growth and equity returns.

China-centered Asia has been the great economic success of the past two decades – yet regional equities have traded around a flat trend. Exhibit 1 shows the Asia ex-Japan MSCI index, in real US$ terms. (To be fair, the ‘flat trend’ glosses over several very significant rallies – and a couple of nasty bear markets.)

This is another example showing that economic growth and equity returns are unconnected. This is true over even very long periods. Exhibit 2 shows the correlation between equity returns and GDP (and GDP per capita) growth over periods of up to 105 years. Ironically, many of the correlations are negative. But the more important point to note is that the explanatory power is very low.

‘The explanatory power is very low’, how beautifully put. But still the majority want to invest where GDP forecasts are highest. It may provide comfort but it just doesn’t work.

The futility of hanging on every news release as a path to investment success has been known for decades. The legendary speculator Jesse Livermore wrote in ‘How to Trade Stocks’ in the early part of the last century;

“It is too difficult to match up world events or current events, or economic events with the movement of the stock market. This is true because the stock market always moves ahead of world events.”

“The market often moves contrary to apparent common sense and world events, as if it had a mind of its own, designed to fool most people, most of the time. Eventually the truth of why it moved as it did will emerge.”

“It is therefore foolish to try and anticipate the movement of the market based on current economic news and current events such as: The Purchasing Managers’ Report, the Balance of Payments, Consumer Price Index and the Unemployment figures, even the rumour of war, because these are already factored into the market.”

“After the market moved it would be rationalised in endless post mortems by the financial pundits and later when the dust had settled, the real economic, political and world events would eventually be brought into focus by historians as to the actual reasons why the market acted as it did. But, by that time it is too late to make any money.”(emphasis added)

Livermore and other great investors do not ignore economic and other news releases, but they do realise that the neat ‘cause and effect’ that so many would like to exist doesn’t. That is why one day a similar release to a previous one could result in exactly the opposite effect in the markets. It all depends upon what is already expected by the majority of market participants. To be a successful investor you do not have to do the impossible and forecast a Black Swan, however, what one should strive for is an understanding of not specifically what a surprise will be but in which direction it is most likely to occur. Will it be a positive surprise or a negative disappointment? These are what move a market, the expected has already been priced in.

Where’s the yield?’

One manifestation of the frustration that has grown out of the meandering, sideways moving markets of both the last couple of years and those of the last decade or more has been the search for yield. During the latter stages of the great bull market that culminated in 2000 no one was interested in yield, capital gains were the only game in town. After the miserable bear market from 2000 to 2003 attitudes began to change and for a while more secure returns from dividends and coupons became more sought after. Once the bull market of the mid 2000’s got into its stride however, and risk appetites grew, capital gains once again came back into vogue and only more risky higher yielding bonds were of interest given the low yields that were by then available from government bonds.

The danger of chasing yield was made horribly real for so many through the GFC and the collapse that was seen in junk bonds and other derivative products. Unfortunately, as so often happens as a terrible memory gradually fades, the same behaviours return and once again the appetite for chasing yields has returned with a vengeance.

This can be seen in the US in the surge of new funds that have flooded into junk bond and high yield exchange traded funds (ETF). Almost half of the more than $28 billion that is invested in this type of ETF has been invested in just the last twelve months. One of the largest such funds, with more than $11 billion in assets, is the Barclays Capital High Yield Bond. The surge in volume can be seen in the chart below, however, despite all this new money chasing the yield of a little over 7% the price has done nothing for two and half years. The real money was made by those brave investors that bought the fund when defaults were at record highs, back in 2009, when fear was also at a peak. Now, with dramatically lower default rates and far less fear, the damage any ‘tail event’ or ‘Black Swan’ might bring about is so much higher.

The old adage of ‘more money being lost chasing yield than at the point of a gun’ does not only apply to unsophisticated individuals. Major corporations succumb as well.

AFLAC chasing yield

For twenty years the share price of AFLAC (American Family Life Assurance Company) outperformed the market in a remarkably steady fashion year after year. It rose virtually without interruption until 2007. Understandably it fell through the GFC but then it bounced back and almost recouped all its lost value by early 2011, but since then it has lagged the market materially, down more than 20% while the overall market is up 5%.

Much of AFLAC’s revenue comes from selling supplemental life insurance, disability and sickness plans in Japan, but that is not the reason for the fall. Business has been fine, the problem, as outlined in Barron’s this weekend, is Europe;

“In a global world of abnormally low interest rates, AFLAC, like insurers and investors the world over, is desperate to invest in assets with good yields, to match its liabilities. Japanese long government bonds—a natural asset for a business that gets 75% of its revenue and 80% of its earnings in yen—yield a paltry 0.80%, even lower than their U.S. counterparts. So AFLAC turned to yen-denominated preferred stocks of European banks, among other issues, in order to improve the performance of its investment portfolio, now about $100 billion. The result: Since the European sovereign debt crisis began in 2010, "every time Europe sneezes, AFLAC stock catches cold," says Thomas Weary, chief investment officer of money-manager Lau Associates. Indeed, the results this year, good as they are, include an investment loss of $272 million or 58 cents per share in the second quarter. Much of that is from European assets, Weary adds.”

Chasing yield can be very harmful to your financial health no matter how sophisticated you are. Another reminder of this was highlighted in another Wall Street Journal article, this time on Royalty Trusts;

Will These Royal Yields Rule?

WSJ August 26^th

“Investors reaching for yield should always bear in mind the warning label on stepladders: "DANGER. DO NOT STAND ON TOP STEP."Just look at what happened this past week to investors in several so-called royalty trusts. These instruments, which collect and distribute income from oil and gas or mining properties, are among the highest-yielding in the stock market, with payouts averaging 9%. But last Wednesday, the "unit," or share, price of Hugoton Royalty Trust fell 8% after it announced a cut in its dividend; on Tuesday, San Juan Basin Royalty Trust also cut it payout, knocking its shares down 5%. And Dominion Resources Black Warrior Trust fell 6% this past week after it declared a dividend cut the previous Friday. Many people—especially older, conservative investors hoping to rejuvenate their shrivelled bond portfolios—might not realize what they are buying when they invest in these rare, peculiar and suddenly popular instruments.”

The article finished with; "Those who stretch too far for yield will probably topple."

With government bonds the world over offering record, or close to record, low yields it is tempting to chase higher returns, but the reason there is a record issuance of junk (high yield) bonds currently is because it is great business, and cheap money for the issuer. Barron’s current yield column titled;

Orgy of Bond Issuance Continues

Concluded with;

“Investors reaching for yield by now have grown used to this unpleasant choice: Buy low-quality bonds when their yields are low and their prices are high, in the hope that the good times will continue, or invest in high-quality bonds at the risk that your cautious intentions will be undercut by rising rates. So far, investors haven’t really been hurt. This month’s new-bond deluge hints that the banks and issuers want to squeeze out every new bond they can right now, while the going is good, because it eventually won’t be.”

When the going stops being good it won’t be those issuers that have already issued that suffer, it will be those that have been on the buy side of the ‘orgy’.

It is probably timely to highlight once again, as I did in the February edition of Strategy Thoughts, that what is considered a yield worth chasing now may not actually be so attractive.

One of the sectors that has seemingly been continually touted by the business media, certainly in the US, has been the ‘high yielding’ utility stocks. The chart below is an update of a chart I originally used in February. It shows the very long term total return of the US utility sector, as well as two very long term indicators of valuation. The cyclically adjusted P/E ratio and the dividend yield. The secular bear, then bull, then bear and finally bull markets are very clear, as are the valuations at each of those inflection points.

As I pointed out seven months ago, the time to buy these utilities was when their yields were in double digits and their long term P/E’s were in single digits. Both those extraordinary opportunities came after the stocks had disappointed for a very long time and no one wanted to buy them, that is why they were so cheap. I concluded the comments back in February;

“Over the last couple of years the utilities index has delivered a very healthy total return and the price index has enjoyed a significant rise. This has merely been a cyclical bull market in a still unfolding secular bear market. It is interesting that there is currently a strong consensus view that high yielders, like utilities, should be a favoured destination for investors. This is understandable given the lack of yield elsewhere and the steady returns that have been delivered by utilities. That level of recognition however, is usually found near the peak of cyclical bull markets, eventually utilities will yield double digits once more and the P/E ratio will once again be in single digits. At that time no one will want to own them, that is why they will be so cheap, and a secular opportunity will once again be presenting itself.”

Whilst utilities may offer yields slightly higher than the rest of the market they are a very long way from offering historic valuations and are yields that should not be chased.

Quality

Older readers may remember Henry Kaufman from the seventies and eighties when he was Salomon Brothers Chief Economist and known as ‘Dr Doom’. Now in his mid eighties he continues as the head of the consulting firm Henry Kaufman and Co. He recently gave a brief interview with Barron’s and shared some of his views on the world and investing. I had a great deal of sympathy for many of his views and his outlook, although it would be fair to say that we look at markets from a quite different perspective. I thought it worthwhile sharing a few of this octogenarian’s observations;

“We are in no man’s land when it comes to economic policies to get the US and Japan out of their doldrums.’

He added that no ‘economic thinker’ had emerged who could galvanize our collective imaginations and show us the way out, and he lamented that such complacency existed about the supposed inevitability of the developing nations picking up the slack from the developed world;

‘There is a halo around the emerging nations that is not deserved. China isn’t working. India has significant problems.’

On the US he said;

‘We have a subdued economic recovery, only 100 or so large companies are cash rich. Small and medium sized companies, the backbone of the economy, have little access to credit’.

On low interest rates;

‘Few investors have benefited from this steep decline in interest rates.’

He noted that;

Much in financial markets and life is comparative. So while our politicians on both sides of the aisle continue to fail us I don’t think we can just cut taxes; we all have to make sacrifices. The US is still much better off than the EU and Japan. Our problems are not as great as China’s. In China, you can’t even be sure of the quality of the statistics.’

He concluded;

‘Try to keep an intermediate view and stay with quality.’

Throughout what remains of the secular bear market I still firmly believe that a focus upon quality will be invaluable. Obviously through each cyclical bull market there are periods where low quality investments rally hard, as was seen in junk bonds from the March 2009 low, however, they have usually fallen far further in the preceding cyclical bear market, and on balance will do poorly over the entire secular bear market.

Closing thought and conclusion

In addition to the ‘Music Men’ article in the Wall Street Journal last month, I was also amused by an column penned by Al Lewis, a regular columnist in the Wall Street Journal, on 26^th August titled ‘50 shades of red ink’. The column was obviously playing on the huge literary smash ‘50 Shades of Grey’ but the focus, I am reliably assured, was quite different. It focussed on the necessity to ‘jump off the fiscal cliff’. Lewis wrote;

“So what do you call a recession followed by a faint recovery, followed by another recession? I’ve called it a depression. That’s why I am ready to take the jump. I would like to see the economy finally hit rock bottom so that it can finally begin to recover from its debt crisis on real terms. No more zombie banks. No more propped-up corporations. No more shadow real-estate inventories. No more funny money flowing into the stock market and pumping up prices. Free-market forces are really going to hurt. But the insane idea that we can avoid them, indefinitely, is bankrupting our nation. Call me an economic sadomasochist. I don’t care. I want leaders who are willing to borrow a line or two from "50 Shades of Grey," like, "I will punish you when you require it, and it will be painful." Feels good. Don’t it?”

The ‘majority’, as I described earlier, want things to go painlessly back to normal. Unfortunately that can’t happen, a price has to be paid and the vast excesses of the prior two decades or more need to be unwound. That can happen quickly and very painfully, as Lewis described, or slowly and frustratingly as they have so far for the last twelve years. Either way the ultimate resolution will be stock markets that are historically exceedingly cheap, expectations that are exceedingly low, and the prevalent attitude towards stocks by the ‘majority’ will by then be one of disgust and disinterest.

Markets are not there yet; the secular bear market, in much of the developed world, still has some way to go. In the meantime an acceptance of the frustrating nature of markets will be invaluable, as will a focus firstly upon ‘QUALITY’, as Dr Kaufman counselled, and secondly, on preserving capital rather than chasing capital gains or yield.

I have been surprised, and frustrated, how far the current rally has run but firmly believe that it is evidence of a decline in the investing ‘crowd’s’ perception of tail risks, not a sign that tail risks have actually diminished. I continue to look for positive surprises out of the US dollar and, as noted last month, believe that for those who have made money out of the decline in interest rates, through holding long dated high quality bonds, that the best returns have been seen.

The Two ‘Great Games’

Many of you know that in addition to investment markets another passion of mine is golf. What you may not know is just how closely the histories of the two ‘Great Games’, golf and investing, are intertwined. That is the focus of a book I have almost completed; ‘Bulls, Birdies, Bogeys and Bears, the remarkable and revealing relationship between Golf and Investment’. Not only does it provide a historical view of golf through an investor’s eye, or an investment market history from a golfer’s perspective, it also provides some predictive tools, particularly when it comes to the Ryder Cup.

If you would like a taste of the book a synopsis of one chapter was published in Hong Kong Golfer earlier this year; http://www.hkgolfer.com/money-matters/bulls-golden-bears-and-tiger . The book is to be published late this year, if you have an interest in an advance signed copy please email me at; [email protected]

Kevin Armstrong

4^th September 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.

Preamble

This month’s Strategy Thoughts By Kevin Armstrong is the second edition written since Kevin resigned from ANZ. For the last four and a half years he has been writing Strategy Thoughts for the ANZ Private Bank and its clients throughout Australia, New Zealand and Asia and prior to that, right back to the 2002 cyclical bear market trough, he wrote Strategy Thoughts for the New Zealand Private Bank. His original reason for writing a monthly paper on his views of investment markets was that it was a very healthy, and valuable, discipline to attempt to put his thoughts on what was important in markets and what was driving markets each month ahead of chairing the bank’s Regional Investment Committee. ECINYA has a very high opinion of Mr Armstrong and we are pleased that he has used our web-site as a transmission vehicle for his unfolding views.

Introduction

In last month’s conclusion I wrote:

“The current cyclical decline, which has been seen in commodities as well as stock markets, probably has further to run. It will end with very depressed expectations, no sign of ‘hope’ from yet another summit, economists slashing forecasts for growth and a global recession probably imminent. By the time these things occur it will probably be the case that the recession (it will eventually be determined) had already started and with rampant gloom and dire forecasts abounding. By then another great opportunity, like those seen in late 2002 or early 2009, will be at hand. For most markets this will be another cyclical opportunity, however, it is possible that some of the most depressed markets may also be on the brink of a new secular bull market.”

Since then markets have generally continued to rally, however, I continue to view the current strength as being a bear market rally driven by rampant ‘hope’. This ‘hope ‘ has been supplied by central bankers committing to do ‘whatever it takes’ and by economic numbers that appear to show things as not being too bad after all. As I have written many times, characteristics such as this are not the foundations that enduring and rewarding bull markets, be they cyclical or secular, are built upon.

In this month’s Strategy Thoughts I will review the extent of the current ‘hope’, question its validity and explore perhaps the overriding characteristic of current markets; frustration. Despite the recent rally virtually all market participants have been frustrated as a result of the meandering nature of markets over the last few months and for many markets over the last decade or more. It has long been said that the primary aim of the market is to frustrate the maximum number of participants for the maximum length of time; currently the market is succeeding in this.

I have also been asked a number of times over the last month just what it would take to make me reconsider my overarching cyclical and secular views. This is a highly pertinent and valuable question so in the second half of this month’s Strategy Thoughts I will review what it would take to make me believe that a secular bear market had indeed ended and also that a new cyclical, and secular, bull market had begun.

Finally I will comment on the risk in chasing yield and the danger of high yield (junk) bonds. Last month I concluded with:

“In the meantime it will be prudent to avoid the excitement and attraction of the ‘hope’ that has accompanied this recent rally, and to maintain a very cautious investment outlook with a particular focus on high quality fixed income, don’t chase yield, and the still relatively depressed US dollar.”

The action of the last month has done nothing to soften these views with the exception that further capital gains are now unlikely in longer dated treasuries and yields may have recorded their final low, this only increases the danger in junk bonds.

Frustration

Levels of frustration are elevated, unusually, for both bulls and bears. Neither has got what they would have wanted from the recent market action, although periodically it has appeared that one or the others preferred, or hoped for, outcome was eventuating. Markets have neither broken out to new highs nor collapsed in a replay of 2008.

That frustration levels are high and rising is entirely understandable, the expectation that shares would outperform all other assets over the long term, which was born out of the remarkable boom period for markets in the eighties and nineties, has been totally misplaced. The MSCI World Index is currently at the same level as it was three months ago, one year ago, twenty one months ago, four years ago, seven years ago, eleven years ago and thirteen years ago. Obviously it has been both a lot higher and a lot lower many times over the last thirteen years but on balance any global investor that bought into the then prevailing conventional wisdom of the late nineties, that the secret to stock market investing was ‘buying and holding’, has been whipsawed several times and undoubtedly left very disappointed. Such disappointing market action over the long term and over the last few months will produce frustration. 

These repeated bouts of frustration, particularly over more recent months, were beautifully described by Jeremy Grantham of GMO in his most recent quarterly letter;

“The economic environment seems to be stuck in a rather unpleasant perpetual loop.  Greece is always about to default; the latest bailout is always about to save the day and yet never seems to; China is always about to collapse but instead teases us by inching down; and I swear the Financial Times is beginning to recycle its reports!  In the U.S., the fiscal cliff looms along with debt limits and the usual election uncertainties.  The dysfunctional U.S. Congress continues for the time being in its intractable ways.  The stock market rises and falls and rises and falls again.  It is getting difficult to find anything new to say at client meetings.  I, for one, wish that the world would get on with whatever is coming next.” 

I would echo those sentiments, but the likelihood is that frustration levels are likely to remain high for some time yet. What I do find remarkable are; the level of hope that remains out there amongst market participants, how little markets have risen on the back of this hope and the fragility of the news that has supposedly produced the hope.

Over the last month there have been innumerable headlines extolling the presence of hope:

Wall Street closes at three-month high on hopes for Europe Reuters, 6 August 2012

Australian sharemarket jumps on US jobs data, bond-buying promise The Australian, 6 August 2012 

Australian stockmarket jumps as hope grows for European action on crisis The Australian, 30 July 2012 

“The US stock market is riding on the wings of hope” written by Greg Weldon via Weldon Financial, 20 July 2012

Even in China there’s hope:

Investors look for hope amid sluggish market China.org.cn, 31 July 2012

And it has not only been in the stock market that hope has been found, it apparently reigns in foreign exchange markets too:

Markets Hope For More QE Forexpros.com, 11 July 2012

Having come across so many stories over the last couple of months explicitly expressing ‘hope’ I decided to do a Google search for the simple phrase ‘Stock Market Hope’. Over the last month alone this search yields over three and a half million hits, this is more than three and a half times the number of hits ‘Stock Market Fear’ generates over the same period. Most of the other months I looked at this ratio tended to only favour hope over fear by a factor of one and half to two times. Clearly this was far from a statistically valid or scientific review, however, it seems to highlight that levels of hope remain high.

Superficially this may appear to be a good thing for markets, unfortunately high levels of hope tend not to be found in the early stages of a cyclical bull market, rather it is found in the early stages of a cyclical bear, and it tends to rise in the back of each bear market rally only to be squashed with each successive decline to a new low. This is why it is said that a bear market ‘slides down a slope of hope’. Another old adage may be that ‘hope springs eternal’, and it usually does, but not at the bottom of a bear market. By then all hope has been abandoned and fear is the dominant sentiment, the vast majority of market participants know just how bad things are and fear that they will only get worse. This backdrop is what lays the foundation for a new cyclical bull market and the climb up the ‘wall of worry’.

Very few, if any, markets displayed anything like such an emotional extreme at their lows two months ago, not even in some of the very depressed European markets. The Spanish market has undoubtedly been amongst the worst performing stock markets since the initial rally after the global financial crisis. The IBEX at its recent low, just ten days ago, was down more than 50% from its 2010 recovery high and more than 60% from its all time high recorded in 2007 but in just the last two weeks that market, on the back of all the news induced hope, has rallied almost 20%. Again, this is not the type of reaction that is seen at the start of an enduring bull market. At bear market lows any good news is dismissed, bad news captures headlines and when the rally begins no one appears to know why the market is rising and the rise is dismissed as just a ‘dead cat bounce’. One only has to think back to March 9^th 2009 for a perfect example of this exact market reaction and response. That day the Dow soared almost 6%, with perfect hindsight we now know that this marked the end of the worst bear market in more than seventy years but very few thought so at the time. The Huffington Post described the move online:

“Wall Street snapped out of its stupor and posted its best performance of the year Tuesday, finding a badly needed glimmer of optimism in the most unlikely of places: Citigroup is actually managing to turn a profit. The 379-point gain for the Dow Jones industrials, a rally of almost 6 percent, was a welcome break from almost uninterrupted selling.”

It then went on to quash any excitement or enthusiasm that the move may have brought about;

“But just as almost nobody expects the banks to snap back to health, almost nobody thinks the market has hit its bottom.”

The rally continued for months and for months the general tone of media commentary was dismissive and bearish as the ‘wall of worry’ was ascended. A similar backdrop was seen in 2003 at the prior cyclical bear market trough. Unfortunately if everyone seemingly ‘knows’ why a market is rising it is more than likely a rally born out of hope not fear, and is therefore only a bear market rally.

What is perhaps most remarkable about the current market action, and sentiment backdrop, is that despite the increasing levels of frustration that are undoubtedly being felt by investors, still, any straw of hope, no matter how fragile, is immediately seized upon and markets rally for a few days or weeks. Reflecting this desire to be optimistic investor expectations for stock market returns remain elevated. Yahoo Finance recently conducted a poll of its readers asking which asset they believed would deliver the best return over the next twelve months. Despite all the frustration that is clearly out there the favourite asset class was the S&P500, beating gold, oil, emerging markets, corporate bonds and US treasuries. 27% favoured the S&P whilst only 4% picked US treasuries, this despite the fact, and contrary to the majority of economic forecasters, treasuries have been the best performing asset over the last one and two years.

But hope is a wonderful thing!

As described above, hope is a wonderful thing and it is human nature to cling to these straws of hope, but just because something is understandable, and even natural, it doesn’t mean it will result in a successful investment outcome. In fact going against ingrained and instinctive biases is far more likely, albeit uncomfortable, to result in success in the investment world. The unfortunate thing is that because behavioural biases are instinctive we humans find it very difficult to learn from past mistakes, and so, eventually, repeat the same mistake again and again. Sometimes the ‘eventually’ is not very long!

Over the last couple of years of the European debt crisis there have been numerous announcements of bailout packages, trillion euro ‘bazookas’, summit meetings and acronyms galore, and after each supposedly positive or constructive outcome European markets have rallied, presumably on the hope that whatever has just been announced will ‘fix’ the problem. Sometimes the rallies in the immediate aftermath of the news have been remarkable. The most recent rally in the Spanish IBEX, described earlier, began after ECB president Draghi’s comments in a Q and A session at an international investment conference held in London to celebrate the opening of the Olympics. He said that the ECB would "do whatever it takes to preserve the euro" and added, "believe me, it will be enough."

This sparked a one day surge in the IBEX on the 26th of July of 7% and initiated the current bounce. But similar reactions had been seen before, and not that long before. On the 29th of June when it was announced that European leaders had reached a ‘deal’ on European banks the IBEX closed nearly 6% higher than it had the prior day. Three weeks earlier, over the weekend of the 9th of June, it was announced that Spanish banks had sought a 100 billion euro bailout. This news was apparently ‘welcomed’ by the markets and on the Monday the IBEX rocketed about 6% higher soon after opening before fading later in the day.

What is remarkable is that all these supposedly good news stories still produce dramatic, albeit usually brief, rallies in a market that has already fallen so far and for so long. After so many ‘fixes’ that turned out to be nothing of the sort the willingness of the investing public to believe that Draghi could do ‘whatever it takes’ seems incredible. If he really could ‘fix’ the problem why has he waited for so long and seen so much damage done to European equity and debt markets?

The reality is that history has repeatedly shown that long term recoveries in markets come not as a result of governmental or central banking policies, but rather in spite of them. Markets eventually begin to recover when investor hope has been quashed and expectations are at rock bottom so that no matter how bad the news is it’s not as bad as the majority feared. They don’t recover when hope continues to bloom with each passing fix.

It is therefore unlikely that even the incredibly depressed Spanish market has yet reached the bottom of the current cyclical bear market. If a market that is already down more than 50% over the last couple of years hasn’t bottomed it is unlikely that a worthwhile buying opportunity exists in markets that are down substantially less, despite the frequent pronouncements as to how cheap some markets may be. As I have repeatedly stated over the years valuation tells an investor nothing about what direction a market is going to move in except over truly long term time frames and then only at historic extremes. The majority of markets, notably the US, that are being heralded as cheap are a very long way from being historically very cheap.

Could anything change this view?

When I was first asked this question I believe that the questioner was primarily interested in my shorter term cyclical view, that equity markets had to fall further and potentially challenge their 2009 lows before a new cyclical bull market could begin. However, in order to answer that question I think it is useful to consider the secular position of markets, in fact I believe it to be essential.

Secular bull markets last up to thirty or forty years and always take a market from an extremely low long term valuation to an extremely high valuation and secular bear markets do the reverse and tend to last about half as long as secular bull markets. There are no hard parameters as to just where a secular bull should end and a bear begin however, the chart below (produced by Smithers and Co, the firm headed by Andrew Smithers who, along with Stephen Wright, wrote the excellent and highly prescient book about, ‘Valuing Wall Street’ in 2000) illustrates two long term measures for valuation of the US equity market. Both have clearly swung from high to low several times over the last century, up swings have coincided with secular bull markets and down swings secular bear markets. The US market in 2000 was historically incredibly expensive, but even at the 2009 lows it was far from being historically cheap. I firmly believe that sometime over the next few years the US market will become historically cheap. That tells us nothing about what the market is going to do over the next few weeks or months but it does tell us that buying and holding will probably continue to be as frustrating an exercise as it has been over the last dozen years.

Given this there is little, barring an unprecedented surge in earnings and so collapse in valuations, that would change my secular view of the US and most developed country markets. A low valuation extreme still lies out there in the future, but this tells us little if anything about how this valuation extreme could be reached, a sudden crash could deliver such a valuation extreme or a grinding sideways market for several years could. This then raises the question of how my shorter term, cyclical view, could be wrong.

Like Jeremy Grantham I too would like the markets to get on with whatever they are going to do. My expectation had been for the major markets to follow a similar, if less extreme, path to the Spanish market and in so doing smash investor expectations and deliver another buying opportunity like those seen in 2003 and 2009. I still consider this the most likely outcome and so continue to believe a very cautious investment strategy is warranted, however, it is possible that the current frustration just continues. Any extension of the current rally would then just be part of an extended period of ever dampening oscillation around a sideways trend in the markets that may eventually produce the disinterest on the part of market participants and valuation extreme that are found at the end of a secular bear market.

This is not unlike what was experienced over the final few years of the last secular bear market in the US. After the market’s most severe decline since the thirties in 1974, when the Dow fell almost in half, the secular bear market was eight years old and only about half over. It rallied sharply from that low point and then over the last seven years of the secular bear market the Dow meandered in a far tighter trading range from about 750 to 1000 characterised by shorter and shallower cyclical bull and bear markets. Eventually, by August 1982 with the Dow at 776, the same level it had been at almost two decades earlier, and at the lowest valuation that had been seen for sixty years, the secular bear market ended and a new secular bull market that would last until 2000 began.

A similar resolution to the current secular bear market may occur, and whilst the cyclical damage may not be as severe as it could be frustration levels would undoubtedly rise and again caution would be warranted.

Is the ‘eye’ passing over again? Or Déjà vu (again)

In May of 2008 I titled Strategy Conclusions ‘The Eye of the Storm?’ as some normality appeared to have returned to markets after a miserable decline over the prior six or seven months. I wrote at the time;

“The dictionary definition of the eye of the storm or the eye of a hurricane goes something like, “a region of calm weather right in the middle of the storm or hurricane” and the danger to the inexperienced weather watcher is that the eye of a storm can result in a false sense of security or safety. It can feel like the worst is passed and that things can get back to normal, however, as the eye moves on the storm begins again with all its former fury, only just to add insult to injury the winds come from totally the opposite direction.”

“The eye of a storm is a very appropriate metaphor for what many investment markets are now experiencing. As I commented in last week’s Thoughts and Observation piece, it is highly unlikely that the worst is over, in fact the mere fact that so many commentators are declaring that the worst is now behind us should actually be taken as something of a contrary indicator, and a warning.”

Our caution at that time was eventually proven to be very well placed; the worst was far from behind us at that time and the worst effects of the Global Financial Crisis had still to be felt.

After the ‘eye’ has passed the second half of a hurricane is never the same as the first although the damage can be just as severe or worse, and so the metaphor played out in markets through the balance of 2008 and into early 2009. History never repeats itself and so it is not surprising that markets through the current cyclical bear market are behaving differently to those four years ago, but history does tend to echo or rhyme. One of those echoes can be seen in the relative lack of volatility currently, particularly in US markets. The VIX, or volatility index, has fallen to its lowest point in four months and is currently at about 15.5 having been close to twice that level just two months ago. In May of 2008, as the last ‘eye’ was passing over, the VIX fell to less than 16 having been a little more than twice that level two months earlier. There is a real possibility that the current calmness, and growing feeling that the worst may have been seen, is as misplaced as it was four years ago.

History doesn’t repeat but I was struck by an updated version of a chart that I used two years ago, it overlays the current secular bear markets in Europe and the US on the Japanese experience eleven years earlier.

The risk in junk, or the danger of ‘chasing yield’

The chart below shows the total return of investing in high yield (or junk) bonds in the US over the last fifteen years. Generally returns have been good, although 2008 was pretty miserable, and they have been particularly good so far this year.

This performance may be understandable, with treasury yields having fallen to historic lows recently it seems the world has been searching for (chasing) yield. As a result the spread, or premium, paid by high yield bonds over the most secure bonds, has narrowed, so pushing the price of junk bonds up even more than the rise seen in government bond prices. This hunger for yield is not only being felt by individual savers but by institutions too. CALPERS, the huge public employee pension fund manager in California recently announced that their fund return for the last twelve months was just 1% compared with their long term expected return of 7.75%, as a result they have reduced their expected return to 7.5%. Expectations on the part of all investors fall through a secular bear market and tend to trough some time after the secular bear market has ended. It would not be surprising to see substantially lower expectations than 7% by the time the current secular bear runs its course. In the meantime return of, rather than return on, will continue to be the most important issue for most investors and their investment capital. The risk in junk may not only be in the bond defaulting, there is now the risk that treasury yields may start to rise along with those very narrow spreads.

For a very long time I have proclaimed the virtues of long dated US treasury bonds, and anticipated that yields would go lower than virtually any economist was forecasting. I also didn’t expect long dated yields to rise until the consensus view had given up on looking for higher rates and accepted low rates for a very long time. In June I wrote;

“Until the fear of deflation and ever lower yields becomes widely embraced and discussed it is likely that further surprises on the downside in yields, not a sudden reversal to the upside, are in prospect.”

At the time ten year treasuries were yielding a little over 1.7%, over the next eight weeks yields plunged, briefly falling below 1.4%. As a result there has been an interesting shift in investor expectations and attitude. Two days ago Bloomberg ran the following story:

Treasury Bears Submit To Fed As Bond Optimism At High

Jay Mueller, who manages $3 billion of bonds for Wells Capital Management in Milwaukee, resisted buying Treasuries for four months, anticipating the Federal Reserve would drop its pledge to keep interest rate at a record low through late 2014. No more. With the economy growing at a 1.5 percent annual pace, the odds of a recession have risen to 60 percent, making 1 percent yields on 10-year notes a possibility, he said. Wells Capital’s parent, Wells Fargo & Co., boosted its Treasury holdings 32 percent to $11.5 billion in May alone, according to the latest data compiled by Bloomberg. “We’re in a low-rate environment for a long time, longer than I had thought,” Mueller said in a July 26 interview at Bloomberg headquarters in New York. “I’m finally throwing in the towel.” So are Pioneer Investment Management Inc., Pacific Investment Management Co., Federated Investors Inc., Northern Trust Global Investments and Columbia Management Investment Advisers LLC. They are adding to holdings of Treasuries as economic growth cools. Of the 20 firms that own the most Treasuries, 16 bought more U.S. government debt during their most-recent reporting periods, Bloomberg data show.

If treasury yields continue to rise, as they have over the last three weeks, and spreads start to widen junk bond returns will start to struggle.

Conclusions

Apart from the possibility of a final low having been seen in treasury yields little has changed over the last month, although it is probable that frustration levels have continued to grow. Hope continues to abound and so the danger of disappointment is high. Secular bear markets continue to roll on in most major equity markets of the world and within those secular bears the current cyclical bear markets have not displayed the kind of give up, or plunge in expectations, that one would expect to see at a cyclical trough. Cautious patience, avoiding frustration, will likely be the most valuable attributes as the current ‘eye’ passes over.

On a personal note my frustration levels have been elevated for reasons outside of the markets, we have spent the last three weeks downsizing now that we are ‘empty nesters’. We have sold our family home and moved to our house by the sea. De-cluttering a lifetime of accumulation in just three weeks is no easy task but I am delighted to say that it is now done. I would also like to say how delighted I have been with the level of interest shown in Strategy Thoughts since my departure from the bank, your comments and questions are always welcome. Finally if you have any friends, colleagues or clients who would like to receive Strategy Thoughts please forward their addresses to [email protected]

Kevin Armstrong

9^th August 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.

PREAMBLE

On Tuesday 10 July Rob, an Ecinya reader, made the following comment in relation to our Strategy Musings of Friday 6 July. He said…...

George, a good article summarising where everything currently stands. The overriding theme throughout the article is that we are in a holding pattern in an event driven market. Could you perhaps elaborate how you are forming the view of being more bullish given the neutral nature of the paper & a decision to not yet revise your downside targets. Looking forward to your response.

Rob, the answer in essential terms is that things change because they have to. The world moves from success to excess, from boom to bust, from recession to recovery, from disequilibrium to growth. Interest rates go down, confidence goes up, earnings recover and valuations improve. Spring follows winter, spring precedes summer, autumn comes, winter returns. The road to recovery is not linear, it is often opaque, it is bumpy in economic and stock-market terms. Timing is always difficult. Ecinya currently believes that we have entered the beginning of the recovery phase and a solid down-leg from here in All Ordinaries, Shanghai, and SP500 terms would provide a technical and fundamentally sound base from which the next sustainable bull-market can begin.

Chaos isn’t dangerous until it begins to look orderly is one of Max Gunther’s Zurich axioms and descriptive of the unfolding of the post US and European banking crisis. There was no GFC, in our opinion, as Asia escaped and it was just a convenient label for Mr Swan, Ms Gillard and Mr Rudd to behave irresponsibly and give hand-outs for Australians to buy flat screens and other electrical devices. Reflation always needs to create sustainable economic outcomes and short-term fiscal stimulus is generally unproductive. Now that the real GFC has arrived Australia has no biscuits left in the tin and fiscal initiatives are being funded by debt.

In part our 6 July Strategy offering said………..

We are becoming a little more bullish, but it is a time to be extremely patient, to allow the global cleansing process to continue to evolve. The conspicuous failures at JP Morgan and Barclays Bank are welcome relief as the scallywags (or criminals) have been exposed. More are sure to follow. This might mean that our 13 January downside target for our global proxy – the SP500- of 1120 (a fall of 18%) comes into view. We hope not, but we are not yet prepared to upgrade that downside target.

Kevin Armstrong, our visiting contributor in ‘Insights’ is firmly of the view that even more substantial downside targets are in prospect. For our part we still believe in the power of fiat currency to save us from cataclysmic market failure. Targeted austerity (aka fiscal discipline) would obviously assist.

We recommend a visit to our last 3 Insight essays so that a competing and, in some respects, a complementary perspective can be obtained. These essays are; ‘the four UNS’, ‘Looking back in order to look forward’, and ‘All roads lead to somewhere’.

On 13 April 2012 our simple thesis was: Europe can’t YET go forward; China can’t go back; America needs to work out where it wants to go; and, Australia needs a Federal election as soon as possible. More than half of our local economy is verging on recession and the stupid carbon and mining taxes that have recently been imposed, have reduced a wavering level of confidence to something near melancholy; savings are up, domestic investment is down, and spending is on the skids. The real engine of pervasive growth, the small business sector, is in disarray. Net collections from the new taxes will probably approximate zero, after compensation and other fiscal expenditures or lack of fiscal discipline.

Going further, time is needed for it to become abundantly clear that the current Federal Rudd-Gillard-Greens government are economic vandals and fraudsters. That is not to say that the alternative has yet convinced themselves, or us, or the broader electorate, that they are a totally viable alternative. An election campaign should help as the detail of the policy debate is revealed. The Labor party, in our view, is likely to replace Ms Gillard in the very near term. An election held this year would, in our view, be a major market positive. ‘In the land of the one-legged drongos, the two legged drongo is king’.

It is clear that Mr Swan is a most inept Treasurer with a running mate as Prime Minister unfortunately out of her depth and clearly lacking the experience to lead the nation. The Labor government overall has become somewhat delusional and the Hawke-Keating-Walsh-Howard-Costello fiscal balance sheet and economic legacy has been comprehensively destroyed.

On a much brighter note it is pleasing to see that global reflation is in the wind as interest rates are shifting to the downside.

 

TARGETS WE SET ON 13 JANUARY 2012

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

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

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

 

TARGET REVISIONS

We now revise our year-end upside target for the S&P 500 to 1380 (from 1350) and upgrade our downside target to 1180 (from 1120). The year-end upgrade is a mere 2.2%, the upgrade to the downside target is 5.1%. However, the more important point is that we are looking for a sell-off in a series of phases that takes the SP500 down about 14% from current levels or about 17% from the 2 April closing peak of 1419. That will, or should, form the basis of the next bull-market, subject to our caveats set later in this paper.

From our Ecinya market quant model the implications for the All Ordinaries (XAO) index is a year-end close around 4310 and a low around 3700. The XAO forecast range thus narrows from 25% to 16%.

All of this means that our January Overview has proven to be near enough to correct, but mostly for the wrong reasons. Let’s find someone to blame….. Ben Bernanke is the obvious choice but the US Congress and Europe have played supporting roles. European bankers could not escape the contagion and poor lending practices of Wall Street. Too many European governments (Germany the big exception) moved too far away from the axiom that "What makes good common sense generally makes good economic sense." The real economy of production of goods and services has been overtaken by the symbol economy of money and credit. The result is a paucity of production and ever-rising levels of unemployment and the result is pessimism and social unrest. Europe has a lot of work to do and structural reform of the Euro must be considered. Our guess is that either Germany or Greece should leave, preferably the former to give the other lesser nations the ability to devalue.

 

WHY DO WE FOCUS SO MUCH ON OUR GLOBAL PROXY, THE S&P 500?

Australia bats at about number 17 in the G20 and America and China are at 1 and 2 respectively. However, in per capita terms China falls over, except that the gap is narrowing relatively quickly. Two of our enduring quotations have come from Ian Macfarlane and our favourite Australian post-war politician, Peter Walsh…………

Ian Macfarlane, former Governor of the Reserve Bank, in June 2005 said:

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

Peter Walsh, Finance Minister under Robert Hawke said, in 2003, criticising his own side of politics:

"All countries which accumulate debt and habitually run big current account deficits are vulnerable.And for many centuries societies have been susceptible to irrational booms,South Sea Bubbles,tulip bulb booms,and dot com busts. But no central bank can offset the cascading effects of bad government policy."

Australia has a narrow and deep export base and a broad and deep import base and it is important that domestic budget surpluses be preserved and that budget deficits be shallow. The Rudd-Gillard-Greens coalition government has departed from this wise counsel and HAS made things ‘worse for itself’. Bad governments historically misallocate scarce resources and this makes it difficult for independent central bankers to move towards lower interest rates. In America the Federal Reserve only pretends to be independent and with the $US being the world’s reserve currency and the US the world’s largest economy, the spillover of bad monetary and fiscal policy to the rest of the world creates difficulties.

 

Ben Bernanke

When Ecinya formulated its 2012 market thesis we never envisaged that Congress would continue to provide stimulus concurrently with Uncle Ben’s QEs and close to zero interest rate settings. The QEs have been so pervasive that corporate America and Wall Street have hardly felt the debacle of the sub-prime crash and the costly wars against Iraq and Afghanistan which have brought into the economic lexicon….. ‘the fiscal cliff’. Fiat money may well be the parachute that saves America from going over the fiscal cliff to a softish landing.

Messrs Greenspan and Bernanke have presided over a new era of economics which have involved commercial excess (Dot-com and sub-prime bubbles) and a dovish approach to TARP followed by money printing cloaked in a tapestry of obfuscation and innuendo. Will we survive it? Will there be a global recession in 2013? Ecinya’s view is YES we will survive and NO there will not be a global recession in 2013.

According to the 31 December, 2011 issue of The Economist, champions of ‘Modern Monetary Theory’ are calling themselves neo-chartalists. They believe "That because paper currency is a creature of the state, governments enjoy more financial freedom than they recognise. The fiscal authorities are free to spend whatever is required to revive their economies and restore employment. They can spend without first collecting taxes; they can borrow without fear of default. Budget makers need not cower before the bond market vigilantes. In fact they need not bother with bond markets at all."

As always conditions precedent prevail and caveats are always blowing in the wind. Our caveats were contained in our essay of 7 October 2011 when we posed the question ‘Is austerity or reflation the pathway to economic recovery?’ Our conclusions were that both were required but in a properly targeted and timed manner. If austerity is happening in global centres then we are only faintly aware of it as the reality and rhetoric diverge. In Australia the various debacles have continued with the latest education handout and the National Disability roll out. Refer below to today’s editorial commentary in The Australian.

In our 7 October essay we envisaged a return to normality. So far we have been completely wrong, especially in relation to timing; fundamental change does not occur quickly. We are now looking to the fourth quarter of 2012 to determine whether we are on track towards a sustainable recovery. Our hopes are high and our analysis is reasonable, in context of economic and market history. Note that the US Republican Party Convention finishes on 27 August and the US election campaigns then begin in earnest. Both parties need to move towards the centre and if they do not then the current mayhem may become somewhat extended. Time will tell.

Our then and current view of ‘normal’ included the following –

What does ‘normalise’ mean?

In our view it includes the following –

• A stronger US dollar.
• A cessation of Congressional hostilities leading to an outbreak of fiscal responsibility.
• The election of a thoughtful and economically literate US president (Mitt Romney seems to have the appropriate CV) or Obama changes his administration to swing to the right towards the centre.
• Tax reform in America… probably a national GST/ sales tax.
• Institutional reform leading to institutional accountability.
• A reduction of European welfare.
• Recapitalisation of European banks.
• Cessation or extreme modification of the European Union and a return to sovereign states allowing some states to use their own currency alongside the Euro. Additionally beneficial trade treaties can be negotiated… not ‘free’ trade agreements, there is no such thing as ‘free’.
• Relative peace in the Middle East aided by a European-Arab reconstruction fund.
• In China we need to see the continued emergence of the middle class and certain safety nets for workers which will increase Chinese production costs and re-balance their trade to some extent. Safety nets.. superannuation, minimum wages, less exploitation, workers comp insurance etc.
• The Chinese Communist Party should change its name to ‘The China Central People’s Party’ to indicate a deper engagement with the west and acknowledgement that it has become a free enterprise economy. China is not yet ready for democracy.

Our summary overview of that October paper was –

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.

Since the first cut of second quarter US 2012 GDP was announced last week at 1.5%, economists have been busily downgrading their Q3 and Q4 forecasts. Fortunately we can take comfort in the fact that most economists rarely get their forecasts right. Thus it would not surprise us if Q4 numbers for 2012 and Q1 numbers for 2013 began to be incrementally upgraded sometime after 30 October. Global forecasts are weakening and a downgrade by the IMF for 2012 and 2013 would also be bullish as they are invariably wrong. We are expecting that at about the market bottom…. a pervasive headline will be "IMF WARNS OF GLOBAL RECESSION".

 

Mario Draghi

Mario is President of the European Central Bank. We were not much impressed with his recent remark that he ‘would save the Euro no mattter what.’ This is the kind of silly statement that push central bankers into corners from which they cannot escape and from which bad policy can flow. It is hard to fathom what he is talking about. Does Germany leave thus saving the Euro for the other underwater nations? Does Greece leave thus saving itself by defaulting? The Euro was a bad concept and it has found to be unwieldy and cumbersome. Asking sovereign states to give up their identity is nonsense. Asking Germany to save everyone else won’t happen. Asking Greeks to pay tax when evasion is a national sport has difficulties. Riots in Spain and Greece are unproductive. A 5 year rolling plan based on fundamental realities would help, but that has not been forthcoming. Instead we have has soemthing like 22 summits and a communique from each about ‘constructive dialogue’. Europe is a wonderful place, a mystical and charming place, but having been bailed out after WW2, it is the land of the free lunch, with some obvious exceptions, but it will take time to get it near enough to right. Mr Draghi so far is not helping. We perhaps should also note that Italians are reluctant taxpayers.

 

THE AUSTRALIAN

 

Ecinya’s response to Mr Swan’s Euromoney award was contained in our essay of 23 September 2011: ‘Mr Swan’s award is a sad metaphor for the world’s economic and banking mayhem.’

Mr Wayne Swan has joined Paul Keating as the second Australian Treasurer to be named by banking magazine ‘Euromoney’ as the world’s finance minister of the year. This seems to be a sad metaphor for the bizarre science that economics has become led by the scallywags of Wall Street and the economic elites of Europe. Australia entered the global financial crisis with a record terms of trade, a domestic surplus and zero foreign debt. Under Mr Swan’s stewardship we have significant debt to be repaid, a domestic deficit, most state budgets pressured, and the prospect that our major economic saviours – China and Asia generally – need to rebalance their economies as Europe and America soften. The steady and pragmatic policies of Hawke-Keating-Walsh and Howard-Costello have been forsaken for failed ideologies of the past and populism and hyperbole of the present.

We found it difficult then, and even more difficult now, to understand how a well regarded magazine like Euromoney could make such an award. The magazine in our view added to instability and uncertainty by being uncaring, shallow and oblivious to the fact that Australia has regressed badly under Mr Swan as Treasurer. In our view at that time Australia became exposed to an Asian and global slow-down which exacerbated the negative trends already evident in the local economy. We bestowed upon Mr Swan the title ‘Australia’s second worst Treasurer’ but did not name the worst. We now upgrade Mr Swan to ‘Australia’s worst ever Treasurer’ and apologise to Mr Frank Crean (the previous worst) and his family. Mr Crean unfortunately fell under the spell of Australia’s second worst post-war Prime Minister, Gough Whitlam.

Just a throwaway note of not much relevance to anything, except Mr Swan’s economic idiocy…… according to the Celebrity Wealth.com web site…. Bruce Springstein is worth US$200 million.

KEVIN ARMSTONG’S STRATEGY THOUGHTS – July 2012

Should we Live in HOPE or Should we Sell The News?

INTRODUCTION

This month’s Strategy Thoughts is the first edition to be written since I resigned from ANZ. For the last four and a half years I have been writing Strategy Thoughts for the ANZ Private Bank and its clients throughout Australia, New Zealand and Asia and prior to that, right back to the 2002 cyclical bear market trough, I wrote Strategy Thoughts for the New Zealand Private Bank.

The original reason for writing a monthly paper on my views of investment markets was that it was a very healthy, and valuable, discipline to attempt to put my thoughts on what was important in markets and what was driving markets each month ahead of my chairing the bank’s Regional Investment Committee. The discipline continues to be of value and so I will continue to write.

The basis of the views expressed in Strategy Thoughts were never economic in nature and valuation has never been used to justify a view except over the very long (secular) term, this will continue to be the case. I firmly believe that investment markets are an accurate depiction, in real time, of investor expectations and so movements in broad markets are a reflection of broad social mood. Expectations, or levels of social mood, are also captured in broad economic numbers but only after a long lag that may be six months or more. This makes forecasting markets by forecasting the movements in the economy a real challenge, an accurate forecast of where the economy will be in six to twelve months likely explains why markets are where they are now. Swings in social mood or expectations, driven by the numerous behavioural biases that drive humanity, from pessimism to euphoria and back, over periods of six months to a few years are the primary drivers of cyclical moves in markets over similar periods; valuation tells an investor nothing over such time frames. Valuation is important as an indicator of where a market will likely go over the very long (secular) term. All markets display secular bull and bear markets that may last three decades or more and the inflection point from secular bull to secular bear is always accompanied by historic extremes in valuation. Over the very long term, long term measures of valuation are an exceptional indicator of long term prospective returns.

In this month’s Strategy Thoughts I will review the rally that has been seen in most ‘risk’ markets throughout June and attempt to put them in some broader perspective, highlight the HOPE that seems to dominate the investment media currently, explore the corporate ‘malfeasance’ that is once again raising its head, this time at Barclays, and finally provide some timely, albeit a little light hearted, secular observations.

Has anything changed?

Over the last month equity markets have rallied and if the media were to be believed (not a good idea usually although they should be studied closely) the rally has been of historically rewarding proportions;

Stocks end first half of 2012 with a bang — CNN Money June 29, 2012

Global stocks, euro, oil rally after euro zone deal Fri Jun 29, 2012

(Reuters) – The euro jumped nearly 2 percent, oil prices surged and world stocks rallied on Friday after euro zone leaders agreed on measures to cut soaring borrowing costs in Italy and Spain, in addition to directly recapitalizing regional banks.

Stocks Log Best Day of 2012, Dow Back in the Black –6 Jun 2012  CNBC

Hope Turns Into Biggest Stock Rally of 2012 — WSJ.com 6^th June 2012

 

Much of the excitement and ‘hope’ on the part of the media and investors has been based upon Europe somehow averting a cataclysm. It is possible that this may indeed happen, however, if one was already a European investor it is quite likely that you would think that whatever ‘they’; governments, central banks, the ‘troika’ or whoever, are going to do, well it’s too late. Investors have already been well and truly beaten up.

The broad Euro Stoxx 50 index of European markets peaked in the second half of 2007, it then fell more than 60% to its low point in early 2009. Along with most other markets it then enjoyed a rewarding cyclical rise of more than 70% but this rally lasted less than a year, the market then entered what for investors must have been a very frustrating trading range moving broadly sideways until the second half of last year. From there it fell by more than 30% into the last quarter of last year. It then recouped about half of what it had lost in the 2011 sell off before rolling over again through April and May of this year. At its recent low point the Euro Stoxx 50 stood at 2050, only 16% above the low point recorded in 2009, but more importantly still down about 35% from where it was in early 2011 and early 2010 and still 55% below where it stood almost five years ago.

For some of the more troubled markets of Europe these numbers make even bleaker reading, but even for the supposed bastion of economic strength in Europe, Germany, the investment experience has been far from a happy one. At the low point at the beginning of June the DAX was down 18% from March of this year, still down 22% since May of last year and 28% from the high points recorded in both July 2007 and March 2000. With this backdrop it is worth reviewing just what the ‘bang up, surging, best days since…..’ rally of the last few weeks has delivered.

Over the last four weeks the DAX has rallied less than 10% and recouped only 45% of the fall, from the March highs, it suffered through to the June lows. The French market has recovered a similar percentage of the fall from the March 2012 highs over the last few weeks but still languishes 48% below where it was in 2007 and nearly 55% below where it was in 2000, even after the recent strength. Finally the Euro Stoxx 50 index has, over the last four weeks, also only recovered about 43% of the decline it suffered from March and is also still well below other recent peaks.

The final headline above perhaps best captures the vulnerability of the recent European solution induced rally and it can be summed up in one word ‘HOPE’. Hope is an understandable, and in many walks of life valuable, human emotion or response, unfortunately it does not tend to serve investors well. There is a reason why it is said that a bear market ‘slides down the slope of hope’.

THE SLOPE OF HOPE LIVES ON!!

The current slide down the ‘slope of hope’ of a cyclical bear market began for most markets in the first half of last year. Certainly that was when most European markets reached their cyclical bull market highs, although for some, as discussed above, those highs were only marginally higher than was recorded a year earlier in early 2010. The reason the adage about the ‘slope of hope’ came about is that it was observed that throughout a cyclical bear market there are always many bear market rallies, and each of those rallies comes about because of hope; hope that the latest government plan, or the central bank’s action, or some other event will reverse the inconvenient decline that is upsetting the majority of investors plans. After the announcement, whatever it may be, the market rallies, and the rise can be self fulfilling for a while as the hope spreads, but eventually the rally falters, it fails to surpass the previous high and as the market rolls over the larger decline continues. There can be many such rallies during the full slide down the ‘slope’ but it is only when all hope has been dashed, as a result of disappointment after disappointment, that the conditions for a new bull market can be found. When expectations, having been repeatedly dashed, are so low, then, virtually any news is good news, no matter how bad it may be in an absolute sense. Cyclical bear markets always bottom amid miserable news, just not as bad as by then investors expect. They do not bottom because of a positive announcement about a solution, to whatever the problem supposedly was, having been found. The initial rise off that bottom of the slope of hope is always greeted with great suspicion and never expected to endure.

From late 2007 through to early 2009 a real time learning opportunity was provided, by most equity markets in the world, as to what a slide down a slope of hope is like. There were numerous rallies on the back of this program or that acronym that were set to ‘fix’ the problem, none of them did. It was only when no solution appeared possible, when Great Depression II had supposedly already begun, in March of 2009, that the conditions of devastated expectations were in place so that no matter how bad the news was it wouldn’t be as dire as the vast majority were by then conditioned to expect. From there the new cyclical bull market began.

In many ways the current decline on the back of Europe’s problems is analogous to that which the world suffered through the Global Financial Crisis, except that the current decline is even more protracted. Perhaps that is why ‘hope’ has been so persistent. After every one of the eighteen, or is it nineteen now, Euro Summits a plan has come out that delivers hope, and a rally. This was seen at the end of last week and it was seen just two weeks earlier, as Barron’s reported;

Hope Lifts Stocks, Trims Bonds Barron’s 11 June 2012

Hopes that central banks will expand liquidity to counter economic weakness and Europe’s debt crisis produced the best week of the year for U.S. equities, which reduced demand for the safe haven of government bonds whose yields had plunged to historic lows.

The media commentary ahead of the much anticipated Greek vote was all focussed upon the HOPE, in fact it seemed in some quarters to be a certainty, that central banks would do whatever was necessary if markets reacted badly. This seemed to add some comfort and prompted a rally in the US market immediately ahead of the weekend vote.  The following headline from the New York Times on the 15^th June captured the spirit of this view;

Central Banks Stand at Ready to Fortify Euro

There were other more extravagant pronouncements like that from Reuters that homed in on the fact that central bankers were ‘checking their ammo’ ahead of the weekend. But the result on that occasion once again was hope. As I wrote earlier the desire to seek comfort in hope is understandable, but unfortunately for investors as long as hope survives, and can repeatedly be rekindled, the bottom has not yet been reached. It really does NOT feel like the conditions for a meaningful market recovery, a new cyclical bull market rather than just another bear market rally, are even close to being in place given the prevalence of the current hope.

 

THE OTHER GREAT HOPE! CENTRAL BANKS

Whilst it may be understandable that we humans cling to and seek hope, it is remarkable that we just don’t seem to learn, even from the relatively recent past. There remains an abiding hope that central bankers will fix whatever the problem is, that they will do ‘whatever it takes’. These are sentiments that are often reported and in some quarters relied upon, what is most surprising to me is that that the same phrases continue to get trotted out and that the faith in the ‘almighty’ central banker is so strong.

Throughout 2008 central banks threw everything they could at the situation, and they may claim victory after the event because ‘Armageddon’ or ‘the end of the world’ was avoided, however, investors should take no comfort from the idea that central bankers can stop markets plunging. After all, from 2007 to 2009 markets the world over fell between fifty and eighty or more percent!

The current HOPE, and the hope that was so present until the very end of the decline in markets associated with the GFC four years ago, that central bankers would conjure up a solution is very reminiscent of the hope that was placed in the so called ‘Plunge Protection Team’ that was formed in the wake of the 1987 crash by Ronald Reagan or as Time Magazine in February 1999 put it ‘The Committee to Save the World’ with a cover photo of Larry Summers, Alan Greenspan and Robert Rubin.

These titans of finance, economics and business were supposed to stop any sort of financial meltdown, three years later world markets had suffered their worst collapse in more than a quarter of a century, the tech bubble had burst and the NASDAQ had fallen 80%. Undoubtedly a ‘plunge’ had occurred but there did not seem to be too much protection. Yet still the media talks about the almost mythical powers of this group to prevent a severe market decline, particularly as ‘they’ also have the supposed ‘Bernanke put’ and everything at his disposal to rely upon as well.

Prior to the Dotcom bust in the early 2000’s and then the GFC there was a general belief that Wall Street couldn’t have a severe decline because ‘The Federal Reserve wouldn’t let it’. The naiveté of this attitude is obvious now after two of the worst declines in history, yet still so many cling to this hope. However, the naiveté should have also been obvious in the late nineties.  A decade earlier there was a similar widespread belief, and hope, that the Japanese market could never suffer a severe decline, because the almighty Ministry of Finance wouldn’t let it happen. It is hard to believe that after witnessing in real time the devastation of the Japanese market from 1989 to now, and the two massive bear markets of the last twelve years, investors still do believe and hope that somehow someone is going to prevent a severe fall. As long as that hope persists, and makes headlines, a bottom has not been seen, irrespective of valuations or economics!

New bull markets are never recognised and understood until they have been in place for some time and delivered a lot of whatever gains they are ultimately going to produce. If a rally is broadly understood and recognised, and the majority know exactly why the market is rising, such as the current rally on the back of the Euro fixes, then it is almost certainly merely a bear market rally on the way down the ‘slope of hope’.

 

IT HAS PASSED!

In March of last year I titled Strategy Thoughts ‘It hasn’t passed yet!’ I chose that title because the month before I had referred to the old adage, that all investors should always remember, ‘This Too Shall Pass’. At the time I was alerting investors to the danger of getting excited or even comfortable with the then growing enthusiasm that was apparent amongst investors, market commentators, economists and strategists, I wrote;

“At such times it is easy to get swept up in the bullish excitement. Unfortunately for investors amongst the most important lessons we ever need to learn is that getting swept up in a crowd, whilst it may feel great, is not the path to investment success. “This time’ is never really different and because as human beings we are hard wired with behavioural biases we never remember the ‘lessons’ we have ‘learnt’ in the past, often as a result of painful experience, just when we need to. That is why it is so important for investors to remember that whatever is occurring in markets, no matter how good, or how bad, it will pass.”

I went on to describe the previous occasion that remembering ‘this too shall pass’ was vital; late 2008;

“Two and a half years ago I employed this title to highlight that the then overwhelmingly depressing gloom that prevailed would pass, and it did. Last month I used it to remind the growing number of newly confident bulls that the current enthusiasm and optimism would also pass, eventually. So far it hasn’t, which is good, as I also implied that even as the longer or intermediate term risks grew, the short term probably would be characterised by an increasing level of confidence and the kind of environment that could ultimately cause one to forget that ‘it will pass’.”

I now believe, as I described above, that the cyclical bull market peak did in fact occur last year or even the year before for some markets and so ‘it’ has passed, however, we continue to see the collective amnesia amongst investors that is always found at turning points. It is hard to battle the behavioural biases that so frequently conspire against us in investment markets and it is hard to remember the ‘lesson’ we find so easy to forget , yet it is essential if we are to succeed.

Not getting swept up in the frequent bouts of ‘hope ‘is one lesson that needs to be remembered, as is not taking comfort from economic forecasts and there is also a lesson that should be learnt from the current banking revelations emanating from Barclays.

 

ECONOMIST FORECASTS!

Over the years I have frequently highlighted the futility of relying upon an economic forecast to build an investment view, the reasons for this are many but one only has to think back to the disaster that was the GFC and the collective failure of the economics ‘industry’ to alert us to that disaster, until it was actually over by which time we were repeatedly being told that it would get worse, to recognise that the ‘industry’ does have shortcomings when it comes to investing. Nonetheless, it seems that many still seek the comfort of an economic rationalisation for what markets will do in the future and are captivated, and comforted, by the seeming exactitude of the forecasts, often to several decimal places. All this despite enduring repeated frustrations as the exactitude and the comfort proves totally misplaced; it is indeed hard to learn from the past. As George Bernard Shaw wrote;

 “We learn from history that we learn nothing from history.”

I was reminded of the beguiling exactitude, if not accuracy, of economic forecasts earlier last month when reading a Bloomberg article on the movement of the Euro;

Euro Strength Seen By Stiglitz Removing Greek Debt — June 12, 2012

The article summarised the forecasts of economists / strategists for the movements of the Euro US dollar exchange rate over the next few years;

“The median estimate of 57 strategists surveyed by Bloomberg is for the euro to trade at $1.26 by the end of the year, dip to $1.25 in 2013, and then strengthen each year until it reaches $1.30 in 2016.”

This truly is a remarkable forecast. Over the last five years the Euro has risen from $1.33 to $1.60, then fallen to $1.25 before rising above $1.50. It then fell below $1.20, reversed and rallied to almost $1.50 and then once again fell below $1.25. The average move in the Euro US dollar exchange rate over just the last five years has been more than twenty percent and each move lasted about a year or less. According to the median forecast from the 57 strategists surveyed by Bloomberg all this volatility is now a thing of the past. Over the balance of this year the Euro will move sideways before falling ONE CENT over the next twelve months and then rising at a rate of a little over a cent a year for the next three years. Well it might happen, but it has to be an incredible long shot. Movements of that magnitude are seen in one week and occasionally over even shorter periods. Such a forecast may appear considered, exact and even sensible, but one with such a low probability of occurring should not be the basis of any investment decisions.

Currently the conventional wisdom amongst forecasters continues to be an outlook that is both benign and hopeful, as it has been for many months now. This benign outlook is based upon the hope that China doesn’t have a hard landing, that Europe continues to muddle through and that the US recovery continues, albeit at a tepid pace. If there is a surprise or disappointment, and it is surprises and disappointments that drive markets, the expected or hoped for is already priced in, then I continue to fear that the hope is misplaced and the outcome will be less benign.

 

WHEN DOES CHANGE OCCUR?…… ALWAYS TOO LATE AND ALWAYS AFTER THE BOTTOM!

One of the hopes that many continue to cling to is that regulations will prevent anything too disastrous happening. Unfortunately history shows that regulators are always outstanding in preventing the last disaster, obviously too late, and then when no disasters happen for an extended period repealing the very rules that prevented disasters, just in time for the next disaster. It is also the case that in addition to regulatory changes, after a financial disaster blame has to be assigned. Most recently this was seen in with the outbreak of so called ‘corporate malfeasance’ in the wake of the dotcom bubble bursting. In every case the malfeasance was taking place while markets were soaring, however, while there are no problems to address no questions get asked and those that do get asked tend to be easily dismissed.

Once markets turn ugly then questions have to be asked and eventually someone has to take the blame. Enron went from being America’s most innovative company six years in a row, as named by Fortune magazine, to filing for bankruptcy in just a matter of months, but the music didn’t stop for Enron until almost two years after the peak in the stock market. By the time Ken Lay, the CEO, was indicted by a grand jury in 2004 the bear market was over and a new bull market had begun. The same was true for Bernie Ebbers of WorldCom.

It was a similar story after the Great Crash in 1929. In the same edition of Strategy Thoughts mentioned earlier, from March 2011, I recommended a remarkable book, “The Hellhound of Wall Street. How Ferdinand Pecora’s investigation of the Great Crash changed American finance”. After such a devastating financial disaster it is understandable that a major investigation would take place, but it didn’t occur until 1933, a year after the Dow bottomed out having fallen 89%. And it wasn’t until five years later that Richard Whitney, the president of the New York Stock Exchange, was sent to jail. Whitney didn’t cause the crash, just as Ebbers, Lay and others did not cause the dotcom collapse, and subprime mortgages did not cause the GFC. All of them were symptoms of the preceding booms that were exposed by the eventual bust and ultimately targeted to take the blame for all the lost fortunes.

None of this is intended to excuse their behaviour, rather it is to highlight the progression of booms and busts that never seems to change because the majority never learn from the past, until it is too late, and then they forget when the next boom arrives.

In the wake of the GFC some regulations were passed, and eventually some very similar to those that had been repealed ahead of it may be reinvented, but it is not clear that much blame, rightly or wrongly, has been assigned. It is likely that one of the signs that the current bear market is over will manifest itself in a far more punitive and aggressive search for ‘someone’ to blame.

Bloomberg this week may have begun that process with their commentary on the Barclays scandal, under the headline;

There’s Something Rotten in Banking Bloomberg 3^rd July 2011

Bloomberg went on to explore what could and eventually probably will happen;

Chief Executive Officer Robert Diamond, who has agreed to forfeit his bonus, shows no sign of following the chairman out the door. He should. In an apology to employees, Diamond wrote that some of the misconduct occurred on his watch, when he was head of Barclays Capital, the investment banking unit. Diamond was already in the doghouse with investors. In April, 27 percent of shareholders, upset that Barclays had missed profit targets, voted down his $19.5 million pay package.

Heads should roll at other banks, too. Regulators and criminal prosecutors, including the U.S. Justice Department, are investigating at least a dozen other firms to determine whether they colluded to rig the rate. Among them: Citigroup Inc., Deutsche Bank AG, HSBC Holdings Plc and UBS AG.

 

BANK BASHING

We don’t countenance bank bashing. Nor have we ever called on regulators to bust up big banks. But it’s difficult to defend an industry that defrauds the market with fake interest rate figures, thereby stealing from other banks and customers.

Sadly, the Libor case reveals something rotten in today’s banking culture. We hope the investigations expose the bad actors, lead to jail terms for those who knowingly manipulated the market, and force out the senior managers and board directors who participated in, or overlooked, such conduct.

Since this article appeared Diamond has resigned but there is likely far more to come, as the article pointed out, but the blame game will probably not get into full force until after the next bull market has begun.

 

CONCLUSIONS

My long term perspective continues to be that the major stock markets of the world, particularly those of Europe and the US, are continuing to unwind the extreme excesses that were seen in the late nineties, excesses of both valuation and expectation. Such secular unwindings tend to take a very long time and are eventually characterised by extremely low valuation and extremely low expectations. It is unlikely that such a point has been reached yet. As result cyclical bull and bear markets, driven by a succession of surprises and disappointments as have been seen over the last dozen years, should be expected going forward. Buying and holding will still likely continue to result in severe frustration, just as it has done since 2000, as will relying on economists or valuation measures no matter how comforting or hopeful they may seem.

The current cyclical decline, which has been seen in commodities as well as stock markets, probably has further to run. It will end with very depressed expectations, no sign of ‘hope’ from yet another summit, economists slashing forecasts for growth and a global recession probably imminent. By the time these things occur it will probably be the case that the recession (it will eventually be determined) had already started and with rampant gloom and dire forecasts abounding. By then another great opportunity, like those seen in late 2002 or early 2009, will be at hand. For most markets this will be another cyclical opportunity, however, it is possible that some of the most depressed markets may also be on the brink of a new secular bull market.

In the meantime it will be prudent to avoid the excitement and attraction of the ‘hope’ that has accompanied this recent rally, and to maintain a very cautious investment outlook with a particular focus on high quality fixed income, don’t chase yield, and the still relatively depressed US dollar.

The old investment adage is ‘buy the rumour sell the news’. Any superficially good news that seems to satisfy the hopeful should probably be sold into.

Kevin Armstrong

 

POSTCRIPT

4^th July 2012

Final thought, another secular perspective: The Late Seventies Revisited?

Travelling in the US and UK a few weeks ago I was struck by the excitement associated with the re-launch and continuation of the hit seventies and eighties TV show ‘Dallas’. The new show premiered a couple of weeks ago and was apparently well received, as a result a second series has already been scheduled for 2013. You may well wonder what on earth Dallas could have to do with markets, well a recurring theme of this month’s Strategy thoughts has been the fact that humans don’t learn from the past. Because of this history does have a tendency to at least rhyme or echo, and there is an uncanny rhyme in the timing of Dallas’ re-launch.

The original show debuted on April 2^nd 1978, just over twelve years into the miserable secular bear market that began at the beginning of 1966 when the Dow touched 1,000 for the first time and it was three and a half years after the 1974 trough, the deepest of that secular bear. It is now a little over three years after the deepest selloff in the current secular bear market and it is also just over twelve years since the start of the current secular bear market in early 2000.

History never does repeat exactly, and who knows whether Dallas this time around will be anything like the cult show it was more than thirty years ago, but it may be worth noting that the seventies secular bear market still had four years to run when Dallas began although the subsequent cyclical bull and bear markets were less severe than those earlier in that secular bear market.

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The views expressed in this document accurately reflect the author’s personal views, including those about any and all of the securities and issuers referred to herein.  The author however makes no representation as to its accuracy or completeness and the information should not be relied upon as such.  All opinions, estimates and forecasts herein reflect the author’s judgements on the date of this document and are subject to change without notice.

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CONCLUSIONS

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.

However, 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 ineffective local and global leadership is not helping. A dose of truth, less innuendo and obfuscation might help.

Ecinya finds it inconceivable that the current bust, after it runs its course, will not lead to another economic boom. The de-leveraging process is nearing an end, the economic skeletons are coming out of the closet, and will be dealt with. A cyclical recovery should not be far away. The current global pressures are a combination of social engineering and financial engineering within a context of globalisation, bringing about an extra 3 billion persons over the past 30 years from emerging nations into the global economy, mainly in manufacturing but also in services such as telecommunications and information technology. Economies that have given up a host of employment will have to regain their enthusiasm for hard work, a shift in the education and training focus, and reduced levels of imports that have created many jobs in China and Asia and other smaller parts of the globe. China, for its part will have to engineer a shift away from export led growth to domestic consumption.

This is not to say that volatility will not persist. Progress will not be linear. Markets have yet to have their capitulation phase. The missing ingredients revolve around politics (especially America), structural reforms in welfare and taxation, and some mitigation of defence spending.

THOUGH THE FOCUS in this paper is on item 5 (highlighted below) from our executive summary of our 2012 Overview paper, many of the other themes are important to full realisation of the global opportunities as the world overall is in better shape today than in the past. Ecinya is of the view that America will re-invent itself and lead a global recovery. BUT a lot of thought leading to full recognition of its problems/ opportunities must be made. Welfare and warfare create vast bureaucracies that we now can ill afford in context of global banking and debt problems and other imbalances The symbol economy is money and credit and the real economy is the production of goods and services. The symbol economy tail has been wagging the real economy dog for far too long.

 

EXECUTIVE SUMMARY – ECINYA’s 2012 OVERVIEW

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

 

BACKGROUND

Almost 3 years ago, when the US and Euro Banking Crisis hit – the USEBC- our editor purchased the BBC Audio discs "The end of the beginning: Winston Churchill’s Greatest Speeches". Note we refuse to call it the GFC which was a convenient excuse for Kevin Rudd’s government to abandon all economic principles.

The assumption was that an understanding as to how a real crisis was handled by statesmen leaders would engender confidence to overcome the prevailing gloom, inertia and malaise.

Today, the electoral cycle within the developed economies has led to mediocrity, unintended consequences, and stupid policy positions including a massive war in Iraq and Afghanistan that has gone over time and over budget. An excess of lawyer-politicians, and bureaucrats have stifled the spirit that enabled the West to win a difficult war and then an expansion of opportunities that ushered in a period of prosperity to surpass any period before it. That prosperity and camaraderie is now under short-term threat from a myopic approach at the institutional level that stifles creativity, entrepreneurship, encourages systemic rorting, and impedes the economic velocity that leads to balanced outcomes.

When America went to war in Iraq George W Bush knew that wars were costly affairs, but he did not realise that winning the war was even more costly as the repair of a broken nation had to be redressed in the name of humanitarianism and good intentions. Thus he entered into an unholy alliance with Alan Greenspan that the American voter had to be placated and encouraged to support the war. Greenspan thus delivered a false prosperity based on easy credit and massive asset appreciation. Prosperity at home would offset any negatives arising from wars abroad.

The Bush-Greenspan-Wall Street Bubble (BGWSB) was exported to an unsuspecting Europe fully immersed in the entitlement society. The BGWSB in America resulted in the Troubled Asset Relief Program (TARP) and the bailing out of various ‘Too Big to Fail’ financial institutions plus the saving of the domestic auto industry. Obviously this had to be done and just as obviously we now have to pay for it. But far too much of that payment is falling on the world’s aspirational middle class where true and sustainable growth emanates. Europe falling victim to the same economic misjudgements now have various sovereign debt problems plus the need to recapitalise a failed banking system. Those that missed out on the BGWS received massive welfare handouts. An indirect cost of war has been ongoing terrorism prevention expenditure and assimilation of refugees.

Common sense economic disciplines disappeared and the ghost of Lord Beveridge, the father of ‘cradle to the grave welfare’ re-appeared. After a hard WW2 the world had gone soft in the head and mind except for the work ethic embedded in the German psyche and the long-dormant ambitions of sleeping tiger China and a colourful and populous India possessed of a strong entrepreneurial sector.

America could easily afford its reckless policy positions as the world’s financial engineer with the world’s reserve currency, and Australia had a mining boom to offset adverse economic repercussions.

 

THE BOTTOM LINE FOR AUSTRALIA

America and the European Union may be ungovernable, Australia is merely dysfunctional.

Australia has a narrow and deep export base and a broad and deep import base and huge capital expenditure requirements, mainly in minerals development.

Despite a mining boom and the most favourable terms of trade ever our federal and state debts are now over circa $300 billion and growing exponentially via a plethora of mythical ‘reforms’ over the past 4 years after having been close to zero in 2007. Additionally, interest rates are too high, income taxes are too high, too many taxes are still hidden embedded in the price of goods and services, confidence is too low, and corporate earnings are under pressure. Additionally, the population is ageing and their superannuation is being decimated.

 

INTRODUCING

WINSTON CHURCHILL (November 1874 – January 1965) was twice prime minister of the United Kingdom, 1940-1945 and 1951-1955). He was a noted statesman and orator, on officer in the British Army, an historian, a writer, and an artist. He received the Nobel Prize in Literature and was the first person to be made an Honorary Citizen of the United States. It is worth noting that his father was a British aristocrat and his mother, Jenny, was an American socialite. As a soldier he saw action in British India, the Sudan, the Second Boer War and the First World War.

DWIGHT D EISENHOWER (October 1890 – March 1969) was 34th President of the United States from 1953 until 1961. Previously he was a West Point graduate who became Supreme Commander of the Allied Forces in Europe during the Second World War. Eisenhower was of Pennsylvania Dutch ancestry, reared in a large family in Kansas by parents with a robust work ethic and as one of five sons was conditioned by a competitive atmosphere which instilled self-reliance.

 

CHURCHILL – focus on the end of the British class system, expanded and accelerated education spend, competition and the opportunity society

In 1942 William Henry Beveridge (later Lord Beveridge) had published his report Social Insurance and Allied Services which many still claim gave rise to the welfare state in England, and perhaps also in broader Europe. The Beveridge report identified five ‘giant evils in society – squalor, ignorance, want, idleness and disease’ and the policy prescriptions were meant to provide for UK residents "from the cradle to the grave". Without referring to Beveridge at all Churchill gave a speech in March 1943 at a time when the European phase of the Second World War was ending and the hardships and deprivations of the war years (1940 -1943) were coming to an end and a future could be talked about with a degree of certainty.

The Beveridge Report was adopted by the British Labour Party and war-time Prime Minister Churchill was defeated in a landslide by Clement Attlee in 1945. Attlee was a devotee of John Maynard Keynes tax and spend policies and adopted the central tenets of the Bevridge Report. Attlee was then was defeated by Churchill in 1951. Ecinya is firmly of the view that Keynes has become a convenient scapegoat for tax and spend policy. Keynes would not have adopted the robust and manic policy positions that his devotees are pursuing today. We now let Churchill speak for himself. Highlights are ours to capture the emphasis in his speech.

This is an edited transcript of BBC Audio’s ‘The End of the beginning: Winston Churchill’s Greatest Speeches’ Volume 2, Track 8.

We must beware of trying to build a society in which nobody counts for anything except a politician or an official, a society where enterprise gains no reward, and thrift no privileges. I say trying to build because of all the races in the world our people will be the last to consent to be governed by a bureaucracy. Freedom is our lifeblood. These two great wars, surging and harrowing men’s souls have made the British nation master in its own house. The people have been rendered conscious that they are coming into their inheritance. The treasures of the past, the toil of the centuries, the long built up conceptions of decent government and fair play.

The tolerance which comes from the free working of parliamentary and electoral institutions. The great colonial possessions for which we are trustees in every part of the globe. All these constitute parts of this inheritance and the nation must be fitted for its responsibilities and high duty.

Human beings are endowed with infinitely varying qualities and dispositions, and each one is different from the other. We cannot make them all the same; it would be a pretty dull world if we did. It is in our power, however ,to secure equal opportunities for all. The facilities for advanced education must be evened out and multiplied. No one who can take advantage of a higher education should be denied his chance. You cannot conduct a modern community except with an adequate, nay an ample supply of persons upon whose education whether humanitarian, technical, or scientific, much time and money has been spent.

We must make plans for part time release from industry so that our young people may have the chance to carry on their general education and also to obtain specialised education which will fit them the better for their work. Under our ancient monarchy, that bulwark of British liberties, that barrier against dictatorships of all kinds, we intend to move forward in a great family. Preserving the comradeships of the war, free forever from the class prejudice, and other forms of snobbery, from which in modern times we have suffered less than most other nations, and from which we are now shaking ourselves entirely free.

Britain is a fertile mother, natural genius springs from the whole people, we have made great progress but we must make far greater progress. We must make sure that the path to the higher functions throughout our society and empire is really open to the children of every family. Whether they can tread that path will depend upon their qualities tested by fair competition. All cannot reach the same level but all must have their chance. I look forward to a Britain so big that she will need to draw her leaders from every type of school and wearing every kind of tie. Tradition may play its part, but broader systems must now rule.

 

EISENHOWER – focus on peace and the dangers of the military-industrial complex

World military spending for 2011 was US$1.63 trillion, with America accounting for $711billion (41%), China $143bn (8%) and the next 8 countries in total accounting for $499bn (29%). American spendt $70bn more than that of the next 9 countries. This seems to be a severe misallocation of resources. $1.6 trillion of total spend is about the current size of the Australian economy in GDP terms.

Extracts from an address by President Dwight D. Eisenhower "The Chance for Peace" delivered before the American Society of Newspaper Editors, April 16, 1953. 

This way was faithful to the spirit that inspired the United Nations: to prohibit strife, to relieve tensions, to banish fears. This way was to control and to reduce armaments. This way was to allow all nations to devote their energies and resources to the great and good tasks of healing the war’s wounds, of clothing and feeding and housing the needy, of perfecting a just political life, of enjoying the fruits of their own free toil.

Every gun that is made, every warship launched, every rocket fired signifies, in the final sense, a theft from those who hunger and are not fed, those who are cold and are not clothed. This world in arms in not spending money alone. It is spending the sweat of its laborers, the genius of its scientists, the hopes of its children.

The cost of one modern heavy bomber is this: a modern brick school in more than 30 cities. It is two electric power plants, each serving a town of 60,000 population. It is two fine, fully equipped hospitals. It is some 50 miles of concrete highway. We pay for a single fighter with a half million bushels of wheat. We pay for a single destroyer with new homes that could have housed more than 8,000 people.

Eisenhower is really talking about opportunity cost, an economic concept, that says if you spend money and resources on one thing the cost is the opportunity foregone to spend on another. Three years out of eight President Eisenhower achieved a balanced budget. Lyndon Johnson achieved one , and Bill Clinton (thanks to Newt Gingrich) achieved four out of eight. There are always competing agendas in government, but overall Eisenhower was a conservative and prudent fiscal manager of prosperity.

In his farewell address on 17 January, 1961 Eisenhower surprised the nation by warning his fellow countrymen of the dangers of the military-industrial complex. The following extracts indicate the depth and tone of that speech:

America’s leadership and prestige depend, not merely upon our unmatched material progress, riches, and military strength, but on how we use our power in the interests of world peace and human betterment.

We have been compelled to create a permanent armaments industry of vast proportions. Added to this, three and a half million men and women are directly engaged in the defence establishment. We annually spend on military security alone more than the net income of all United States Corporations….. The total influence – economic, political, even spiritual – is felt in every city, every statehouse, every office of the federal government. We recognise the imperative need for this development. Yet we must NOT fail to comprehend its grave implications……. In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military-industrial complex. The potential for the disastrous rise of misplaced power exists and will persist.

There are some who believe that America is always looking for the next war to fight. On 7 June 2012 China and Russia vowed to step up joint military exercises raising fears of a regional arms race after Washington declared the US Navy was bolstering its presence in the Asia Pacific. Australia has recently granted space to an American force resident in the Northern Territory and China has reacted by saying that cold war attitudes are unwelcome. It should be stated that war with China is not an option nor is it likely. But we stress that peace requires pervasive prosperity because there is always a politician somewhere that will blame some other country for its own failings. A cranky populace is easily susceptible to propaganda from a stupid and myopic politician. Our fundamental concern is that we should be wary of misallocating resources in pursuit of ridiculous ends.

 

 

A BRIEF ANALYSIS OF THE GLOBAL FINANCIAL CRISIS WITH SPECIAL EMPHASIS ON AUSTRALIA AND THE ROLE BEING PLAYED BY THE PRIME MINISTER, KEVIN RUDD.

 

OVERVIEW

This has been written to attempt a brief articulation of a major concern that far from saving Australia from the ‘global financial crisis’ the actions, rhetoric and policies of the current Australian government are going to totally immerse us in it, or delay our recovery from it, or both. We are just 1% of the global economy. Time is needed to see where the stimulus packages of China, America and Europe will lead the world. Current local policy prescriptions seem to be pre-emptive, excessive, and poorly targeted.

Ecinya has suggested that payroll tax relief, personal tax cuts being brought forward, and some relaxation of capital gains taxes for long-term residential property holders upon sale would provide sufficient short-term relief. We are totally opposed to the $950 per person hand-out which apparently will cost about $11 billion and we don’t understand the pre-occupation with direct infusions for commercial property as opposed to working through the banking system. We are strongly in favour of infrastructure spending, but the schools programme is blatantly political and can unfold more slowly than currently envisaged. Some of the ‘green’ programmes seem also to be politically inspired.

On the rhetorical side we have suggested that ‘balanced free enterprise’ replace ‘capitalism’ and ‘socialism’; that ‘beneficial trade’ replace ‘free’ trade; and that the Chinese Communist Party change its name to the ‘China Central People’s Party’ to mitigate cheap shots from the west during its past 30 year transition and integration into the global economy.

(postscript 11/2/09: Two of my confidants (esteemed colleagues) found it an unwelcome and irrelevant diversion that China should be mentioned in this prologue. They seemed sufficiently chastened when it was pointed out to them that China was currently central banker to the world economy, that China and the US between them account for close to 30% of global GDP, that China had provided about 25% of world GDP growth over the past 8 years, and therefore, needed to become a fully fledged member of the global financial community. The word ‘communist’ enables rednecks and assorted ideologues to treat them with insufficient respect.)

We do not share Mr Rudd’s convenient faith in the International Monetary Fund and despite our long-held support for Mr Obama (since 2006) his success is far from guaranteed, given the recent performances of the US Congress and statutory agencies. He has to overcome significant congressional obstacles and tear down some false fiscal and political gods and prophets, and embrace some others with his own balanced perspective.

Prosperity is the tide that carries us to realisation of our social and material aspirations and re-leveraging the public sector to de-leverage the private sector is fraught with difficulty and invites unintended consequences. One cannot help but feel that Mr Rudd is out of his depth and being overtaken by his personal ambitions

THE ECINYA RESPONSE

Even at schoolboy level we are taught that the daily economic battle is between ‘wants, which are unlimited in extent and variety, and resources, which are limited.’

The Austrian school of economics places great emphasis on the fact that mis-allocation of (scarce) resources is at the epi-centre of sub-optimal or bad economic outcomes. Bad policy is bad policy. Good policy poorly implemented results in bad outcomes. The results are all too obvious – inflation, high interest rates and taxes, low productivity, excess capacity, current account deficits, poor health-care etc.

THIS RECESSION has been a long time in the making. It has been an evolution and no talk of ‘revolution’ or the adoption of one of the ‘isms’ such as ‘social democratism’ will achieve a sustainable solution. It is equally true that laying the blame at the feet of any other ‘ism’ provides an unsound framework for sustainable solutions.

BUT if we had to choose an ‘ism’ we would select ‘common sensism’. In economics, what doesn’t make good common sense is hardly likely to make good economic sense. There is no single ‘ism’ that fully explains what has happened, what is happening, and what will happen. The world is a hybrid – all of the ‘isms’ swirl around in a dynamic framework, sometimes winning and sometimes losing. This can be referred to as ‘cycles’.

Prime Minister Rudd’s lengthy essay, written in conjunction with advisors and colleagues "with common interest in the ideological origins of the current crisis", adds nothing to the debate. Rather, it gets lost in an intellectual indulgence that fails to understand the role of the government in context of a parliamentary democracy where even the Opposition is elected to give voice to the people. "President" Rudd, just like Messrs Bush and Cheney, believes in Executive Government where parliament is expected to endorse, support, anticipate and agree with the Government of the day. It is convenient to label dissenters as ‘ideologues’, ‘radicals’, ‘racists’, ‘neo -liberals’, or ‘the do-nothing brigade’.

Mr Rudd’s "analysis" leaves out some important contributing factors – the role that the Australian states play in industrial relations, in health, in education and other areas of spending such as infrastructure, and for the most part of the recent boom, those states were Labor. Mr Costa, in the article mentioned above, says: "So deregulation, privatisation, greater market competition and expanded private participation in equity markets through compulsory super, is OK if it’s undertaken by Australian Labor governments, but it is neo-liberal ideology if anybody else does it. All the way through his essay Rudd tries to have it both ways, cherry-picking economic history to support his political prejudices."

Ecinya respectfully suggests that Mr Rudd has been caught by the gentle breezes of Kirribilli House, the star filled nights, the easy harbour-side celebrations, and with aligned minds in attendance, each with a glass of chardonnay poured from the public purse, is moving to govern through the prism of his ego or his own lack of self -esteem, or some other psychological disorder. There is no air of quiet confidence that creates a sense of managerial competence. Rather, there is a sense of papal infallibility. If God had meant politicians to lie he would not have invented behaviours like obfuscation, false and misleading and deceptive conduct, innuendo or delusions of grandeur. Mr Rudd was elected to govern, not ordained. Government is principally about economic management, law and order, and future investment (education, social and commercial infrastructure).

On a more global perspective he fails to mention the economic leakage caused by the wars in Afghanistan and Iraq, and the major transfers of wealth caused by the oil price surge, and the out-sourcing of global production to China, India, Mexico, Brazil, Canada and elsewhere. Essentially, Mr Greenspan gave the world this recession, this ‘crisis’, by creating a false economic boom to hide a war based on falsehoods. This is a ‘made in America’ recession. Led by the local branches of the Wall Street machines like lambs to the slaughter, we all participated with gusto and glee. The music has stopped, the game of musical chairs is over, and many old maids find themselves unseated. A wolf in sheep’s clothing provides no solution.

 

CONTEXTUAL ESSAYS (please click essay title for full text)