Taking Risks and Reaping Rewards

Another Sign of China's Collapse

Often times I hope I am wrong.

The FT reported that forest land that is to be preserved has been used as collateral in bank loans to build infrastructure by local governments. So if the loans go bad, they will have to sell the land to pay off the debt.

Since they are unlikely to be willing to part with large tracks of forest and other natural wonders, a bank bailout would be the natural option.

But why would the loans go bad?

Because no one is using the buildings that were built by their funds.

The FT reported that Chenggong is a new town near Kunming, one of the main cities in the south-west of China.

Construction started in 2003 and the results are now apparent in 13 immaculate local government buildings, each clad in marble tiles.

A high school boasts an impressive indoor swimming pool and several of the region's main universities have built large campuses.

Pristine high-rise apartment blocks stand in rows, their new windows glinting in the subtropical sun.

The one drawback: at the moment, Chenggong is almost completely empty. Its wide streets are all but bereft of traffic, a bank branch has no customers and leaves collect in the foyers of the municipal offices.

What's worse is that haven't stopped building or borrowing to do so. While China's GDP has grown substantially, the debt to GDP ratio has barely budged. The explanation of this is that the growth was from spending by state-owned financial institutions, not directly from the government. Loans last year more than doubled to nearly a third of GDP. 

Can you say unsustainable?

To put that in perspective it would be as if Bank of America Wells Fargo, etc. were state owned and they loaned out 33% of GDP, which would be almost $5,000,000,000,000.00 (trillion) if it were happening here. 

Investment that was once 25% of the Chinese economy is now more like 50%.That means that for every dollar (yuan) spent in China, 50 cents of it is by the government. Again in perspective, that would be $7,000,000,000,000.00 (trillion) in government spending if it were happening here.

China is trying to increase domestic consumption, reduce foreign demand, and reduce government spending, but it's a long and difficult process. One that we hope will go smoothly, but as I often say, hope is not an investment strategy.

Here's why it matters to you

When the highly likely burst of the China property bubble occurs, the repercussions won't stay inside their borders. It would easily drag the rest of the world into a double dip recession.

And we are pretty much out of economic bullets to shoot at another recession, so the next one will likely be worse than the last one.

Worse yet, China could be forced to quickly appreciate their currency which they have pegged to the dollar and is keeping our imported purchases of their goods at low prices, or they might dump the US government debt which they own plenty of. Either would send the dollar plummeting and the prices of imported goods skyrocketing.

And if that happened with no economic bullets left in our gun, well...let's just not go there before we have to.  

In conclusion, with no one living in an entire new city, it's hard to think that everything will be fine and this will all work itself out, but I sure hope I am wrong.

Are All-Cash Home Sales Good or Bad?

Data released today by the National Association of Realtors on US home sales in February showed a decline of 0.6% and inventory surged by the most for the January-February period in 20 years.

But what may be more telling is that all-cash sales remain at a extraordinary percent of the total at 27%. Typically, all-cash sales fall around 10% of total sales.

 

 

 

 

 

 

 

 

 

What can we learn from this?

First, any data that hits a long term high or low water mark or is outside the ordinary deserves special note. To find a clue about the future, think about why this unusual event happened and what is likely to push it back toward the average.

Second and more specifically, housing prices are being supported by a tax credit that is about to expire and many of the buyers are speculators that are going to want to sell again in the future. So while those homes are off the books for now, they will come eventually. 

The good news here is that the all-cash speculators can sit and wait without default. So there will be fewer bankruptcies going forward.

But the bad news is that there will be lower demand going forward and higher supply, so prices will naturally decline for some period of time.

Speculators paying all cash can wait for years for the market to rise. If you can't, prepare accordingly.

The Sure Double Dip

It's not often we clearly see an iceberg through the windshield filled with our foggy future, but Meredith Whitney says she has seen one when she said, "The housing market surely will double dip."

When we hear such comments there are two things that we need to think about before we accept or reject what they have said.

The first is, "How credible is the source and what bias might they have?"

The second is, "How did they come to their conclusion and do we agree or disagree with their method and findings?"

In this case, Ms. Whitney's resume is solid in both education and professional experience. She was named "Power Player of 2008" by CNBC beating out Warren Buffett, Ben Bernanke, and everyone else.

More importantly she runs her own firm which means her bias is to being correct as it will reflect directly on her. In other words, she might not be right, but she's not trying to pull the wool over our eyes or mislead us in any way. If she says it, she believes it. (This is way less prevalent that you might like to think).

I also love the fact she married a professional wrestler. To me, this means that this is a strong person that makes her own decisions and isn't looking for approval from outsiders. And she has what we all should be looking for: independent thoughts.

So if we don't dismiss her comments out of hand, then we need to understand why she thinks this way and see if we agree.

Her reason is that the housing market has been supported by government programs, such as loan modifications and buying of Mortgage Backed Securities (MBS), and as those programs are coming to an end, a lot of supply will hit the market.

Basically, it's more supply, less demand, prices fall, in this case, AGAIN.

Is that true? Well, yes the Fed has said quite clearly they are ending the mortgage support. If they do, will others pick up the slack? Probably not as there isn't any profit in it for them to modify loans unless the government is forcing them or sponsoring it. So this is pretty clear analysis to me. 

Does that sound logical and right? Yea, probably does.

But can we find hard evidence to confirm our suspicion that she's really on to something?

In a previous post, I addressed wall of mortgage resets coming. That clearly showed evidence that a ton more mortgages are going to get hit with large resets, which will mean defaults for many or most of them. This will happen in the next year or two.

Read this again, then think consider that Ms. Whitney is an expert in this and has built her reputation on being right.

What can you learn from this?

It's likely that there will be another housing downturn, plan accordingly.

More importantly, there are at minimum two things to think through when you hear someone make a prediction in such clear language.

One is who they are, why they are saying it (bias) and make a judgment call about their credibility.

Two is how did they come to their conclusion and can you find evidence to confirm or reject it. Evidence counts, hoping they are right or wrong doesn't.

Remember: Hope is not an investment strategy.

Chugging Ahead or Are We?

The Federal Reserve Open Market Committee (FOMC) left interest rates unchanged and released a statement that updated their position on the economy just a bit. A comparison of this statement vs. the previous one in January can be found HERE.

Notable changes were changing the words "Deterioration in the labor market was abating" to "The labor market is stabilizing." While that's little consolation if you are out of a job, it's clearly a minor improvement.

Also, the addition of "business spending has risen significantly" is a positive sign as is the removal of the special liquidity they put in place during the crisis.

Could this be a return to normalcy? Are we going to just go chugging ahead?

Maybe.

But before we go to our cabin and take a nap feeling all is well, it should be noted that what they didn't change may be more telling.

They continue with language that "bank lending continues to contract" which means that banks are doing something other than lending with their money.

The one dissenting vote, from Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, continued his stance that things have "improved enough that the expectation of low rates for an extended period was no longer warranted because it could lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability."

What can you learn from this?

The economy is still in need of help because otherwise they would be moving interest rates up to more normal levels.

The rear view mirror shows some positive signs that we are headed on the right path, but the windshield is still foggy and there are still some icebergs out there.

So full steam ahead is very risky.

The reduction in the special liquidity is the first step in normalizing monetary policy and before they move interest rates, the Fed will have to see how the market reacts to the reduction this action.

The potential for another bubble is already forming. (or worse, one has already formed!) This is the concern of Fed President Hoenig.

Me too.

The banks are able to borrow money at basically zero percent. Anything they do with it is a positive return. They could lend this money to consumers or businesses, but consumers aren't interested in excessive borrowing and small businesses are risky. So banks take that interest free money and invest it in stocks and other assets that they can sell quickly should an iceberg appear. Also, they are still using leverage, perhaps high leverage, which exacerbates the problem and increases their desire to pull back quickly at any sign of real trouble.

That desire to pull back the sign of trouble wouldn't be there if asset prices were fairly valued. But the markets are priced at levels that anticipate a solid future expansion. If that's not what happens, all that money put into the markets will disappear, probably fairly quickly. The potential for a quick pull back combines with plenty of potential reasons to have a pull back to provide clear concern about the foggy future.

Icebergs...I hate icebergs.

Spiraling Around in Circles

February's jobs report said that unemployment, despite snow in the northeast, held steady at 9.7%.

We lost 36,000 jobs net and that was greeted as good news by the markets as it could have been worse.

What we can learn from this.

Think of the economy as a spiral. We spiral up and we spiral down.

Right now we are spiraling around in circles and I am getting a bit dizzy.

While that is better than spiraling down, before things truly get better, we need to start spiraling up.

On the other hand, there is still a chance we could spiral back down.

Crossroads methinks.

Pension Canaries in the Coal Mine

Today the Financial Times reported that "California has acted as the canary in a financial coal mine lately for the rest of the US."

They have recognized the problem of promising much without the ability to deliver. But they haven't got a real solution.

"Northwestern University calculated before the latest bear market that, using risk-adjusted assumptions, there was a 50 per cent chance of a shortfall of $2,660,000,000,000. Andrew Biggs, a former Social Security economist, said private sector actuaries would peg public shortfalls at $3,500,000,000,000. Basically 25% of GDP."

The Canary is dead, but how do we evacuate the coal mine?

Currently, it appears that everyone just hopes for a miracle. But as I often say, "Hope is Not a Strategy"

 Why this is important to you

The only solution to this shortfall, unless some magic investment scheme is developed where the pensions can generate abnormal returns, is a combination of borrowing to pay the bill, rasing taxes, or lowering benefits.

• Borrowing is just about out of the question as we already used this leg of the stool to get where we are at. 
• Raising taxes is politically challenging.
• Lowering benefits is also politically challenging.

The result will likely be a combination of the two which means higher taxes in the future. 

And this isn't just true of California, hence the canary in the coal mine reference. When the California Canary dies, it means that it's not safe for anyone. 

 

Risk and Reward Biotech Style

Potentially large rewards come with significant risks.

There is no better example than developing new drugs.

Medivation, a biotech company. set an all time high on it's stock price on Tuesday of $40.49 due to it's new hopeful Alzheimer's treatment. But when results were announced today that it failed to be effective in a large scale study, Wednesday the stock plunged almost 70%.

In this example, you can clearly see how the market works in a classic case of buy on the rumor, sell on the news.

In anticipation of the success of the drug, the stock ran up to an all time high. The market buys on the rumor, or hope, that the drug will be successful.

As the release date of the trial study approaches, the market moves up in anticipation of good news. Then when the news is bad, especially this bad, the stock sells on the news.

It can, as it did here, fall off a cliff. (Biotech is especially susceptible to this as their trial results are typically binary, either they pass or they fail.)

But even if the trail had been successful, the stock  may have sold off as the success of the trial may have already been priced in. Stocks fall on good news quite often because the market is anticipating it.

Of course in this case, we will never know how much it could have moved up if it was successful, if at all.The point is that there's no guarantee it would skyrocket further. It typically too late to buy after the news is released.

What can we learn from this?

At least two things.

1. Don't measure decisions by results. The investors in this company took a risk based on information on the potential of significant profits if the drug has been successful.

It's not useful to think of this as a bad decision because the risk didn't pay off. It's far more useful to measure the decision by how well they did their analysis. Did they consider all the information correctly and were the the probabilities actually in their favor?

If so, the decision was correct, regardless of the result. 

Think of it this way. If they odds on the success of the drug were 100 to 1, but the payoff if was successful was 1,000,000 to 1, then the correct decision is to make the bet and buy the stock. But if the odds were reversed, then they made a bad decision. 

It's all about the analysis of the probability of success because the outcome isn't certain.

So the goal is to analyze the potential for success correctly and choose those investments that put the odds in your favor. If you find you aren't doing well, it's because you aren't analyzing the chances of success correctly. 

Focus on the risk and keep putting the odds in your favor.

2. The market is forward looking. Those that bought this stock did so in anticipation of a successful drug trial, not because it was already successful.

They were looking out the foggy windshield and saw what they thought was a pot of gold. But when the fog cleared, the gold turned out to be a mirage and they drove off a cliff.

However, if they didn't didn't drive toward the pot of goal in the first place, they never would have had the opportunity to profit if it was real. Others would have beat them to it.

No risk, no reward, but take smart risks.

 

Basically, It's Over...Or Is It?

Warren Buffett, the Oracle of Omaha and the second richest person in the world, released his annual shareholder letter recently.

This is required reading for any investment professional. They already know that.

You should read it too. But assuming you won't, I will try to summarize the salient points from which you can learn and apply to your own situation.

In case you aren't aware Mr. Buffett has a partner and consigliere in Charlie Munger.

And that's where we'll start.

Mr. Munger's sharp mind has been written about for quite sometime as he clearly sees through the fog and cuts to the chase. His recent article entitled, "Basically, It's Over" isn't to be taken lightly. 

Again, THIS IS MUST READING for anyone concerned about the world around us.

He calls it a parable about how one nation came to financial ruin. Clearly this as a warning shot across the bow of our current economic brouhaha.

Pessimistic? Yes.

Too pessimistic? Maybe.

Clearly on point with a valuable message? Duh! Of course.

Expect nothing less from Mr. Munger.

Here's here's a quick take on this:

• People with a vested interest don't care about much else. It's difficult to fix our problems because to do so would impact the profiteering of someone else. To protect those profits, they make political contributions to prevent the fix. Hence, same old, same old. Which won't work forever, because...
  
• Avoiding trouble doesn't make it go away.  Our health care situation is untenable long term as is our fascination of short term "casino" profits over long term wealth creation. But...
• This can go on for a long time. We won't collapse overnight, again. We almost did that just a short time ago. So we have a bit of time until it will happen again. However we are clearly still speeding toward a cliff. If we don't change our course...
• It will very likely will come to a sorrowful conclusion. The longer we continue on our current road, the more painful the conclusion will be. And if course isn't going to change, you need to...
• Make sure you aren't sorrowful when it concludes. If leaders won't listen to BenFranklin LeeKwonYou Volkker (read the article to understand this reference), they aren't going to listen to you or me. So your best move is to stay abreast of the situation and use our understanding of it to your advantage.

(Warning... this requires real work - actually reading and thinking. If you are out of practice at either, now is the time to start training.)

So is it basically over?

Clearly not for Mr. Munger or Mr. Buffett. 

I am doing what I can to make sure it's not over for me either.

Hopefully, it won't be over for you. But that depends on you.(Did you read the article yet? Again, work required. You might want to start there.)

The Trend in Jobs isn't Our Friend

There's an old saying, the trend is your friend. 

But the converse is true when things trend the wrong way.

Initial jobless claims rose 22,000 to a seasonally adjusted 496,000 in the week that ended Feb. 20, the Labor Department said Thursday. 

 

The four-week moving average, which helps smooth volatility in the data, was up 6,000 to 473,750. Continuing claims, which are drawn by workers for more than a week, also rose by 6,000 to 4.6 million in the week ended Feb. 13. 

The news initially hit stocks pretty hard.

Duh.

But a small change percentage change isn't the key here, nor is the half a million initial jobless claims. While the horrible weather may have contributed to this, nevertheless, it's the trend change that is disturbing.

We were headed on a clear path toward fewer and fewer jobless claims. This last series of data shows that trend may reverse, putting a crimp into our hopes of economic recovery.

What can we learn from this  

Individual data points don't tell us enough information to see into the foggy future. But trends, even though they are in the rear view mirror, can help. They confirm our previous suspicions and tell us when the road is changing direction. 

Sure the path to recovery is going to hit bumps in the road, and this isn't a pothole we hit or a fall off a cliff.

However, if you are forecasting a recovery in jobs, then you are forecasting a decrease in initial jobless claims. That doesn't change with one data point. But a change in the trend will have impact.

Has the trend changed?

Well, maybe. 

But that uncertainty is why we are looking at it.

The trend is your friend only because you recognize it and use it to your advantage. 

Keep an eye on changes in trends and reversals. They may be the caution sign that prevents you from running off the road.

Ouch! Your Lack of Confidence Really Hurts

This can't be spun to be anything that painful, bad news.

Today, the new economic data shows a decided drop in consumer confidence.

The Conference Board, a private research group, said its index of consumer confidence declined by 10 points or fell by almost 20%!

In February the index fell to 46.0, from a revised 56.5 in January. The February reading was far below expectations by economists.

The present situation index, a gage of consumers' assessment of current economic conditions, fell to 19.4 this month from 25.2 in January, originally reported as 25.0. The February index was the lowest in 27 years. 

(Note: Always pay attention to numbers that are the the highest or lowest in decades.)

Why this is important to you

The economy is comprised of (C) consumer spending, (I) business spending or investment, (G) government spending, and (NX) net exports - the difference in what is spent on domestic goods minus what is spent on foreign goods. 

The breakdown (in round numbers) is 70% C + 20% I + 20% G + (-10%) NX for 100% of the Gross Domestic Product or GDP.

If consumers aren't confident, they don't spend. If they don't spend, given that they (we) are 70% of the economy, the economy can't grow. If they economy doesn't grow, it does the opposite. It goes into recession. 

What's worse than one isolated number is that now it will hit the news wires and stories will circulate, like this one, that say the economy is in trouble. That will add to a downward pressure on confidence which can start feeding upon itself creating a downward spiral. 

That's why this wasn't good news at all for anyone.

Ouch! That's going to leave a mark.