Investments for 2012

Investors are worried. On one had inflation theatens to reduce the value of the money holdings and on the other hand, they may lose money if they invest. Stocks can be volatile and has not plumbed to the depths of the past financial crisis of 2008 OF WHICH THE WORLD HAS NOT RESOLVED. Banks in US continues to pay obscene bonuses , Companies are robbed dry by their CEO and senior executives who speculate with companies's money to get huge bonus. Tom Cook who replace Steve Jobs at Apple  is said to receive an annual compensation package in excess of US$300 million.

Banks sells investment products with layers of hidden fees and commissions. They are ruthless in their pursuit of profitability. So what to invest in? Bonds may decline in value once interest rates spikes up. The recent high interests paid by the Italian Government shows that interest can shoot to over 7%. Imagine you had a year ago bought Italian sovereign bonds with a coupon rate of 3.5%.  The increase in coupon rate would cause your bond to drop in value substantially.

Properties in Singapore are now in suspended animation where the direction up or down is not clear. If we cannot invest in stocks, hedge funds, private equities , bonds or properties what can we invest in?  We can invest in shares of companies with good long term prospects. This means we must be prepared to ride the down cycle and hold on to these assets. Think of yourself as not holding stocks but hard assets. Assets can be physical or intangible as in intellectual properties.

What does the world need in the longer term  whether there is a financial crisis or not? The world population is increasing and the increasing middle class in China, India and Indonesia will eat more meat , fish and consume more milk. I would invest in companies that have links , the more direct the better, to food production. If I had the funds, I would start a private equity fund investing in companies that are into producing more food with less inputs. There are agricultural commodities funds but one needs to look beyond the name to see what they actually invest in. Many commodities funds don't invest in hard assets but in options which fluctuate with the prices. Avoid these.

Market Vector Agricultural ETF invests in large companies related to agribusiness. It has holdings in Potash Corporation, the world 's largest manfacturer of fertilisers, Mosanto which is well known for its genetically modified seeds  and claims that it can increase yields dramatically, Deere & Company which makes large farm machines and Wilmar, one of the largest palm oil plantation companies in the world. Its expense ratio is 0.56% and if you hold for four years, your holding costs is less than 3% .  In four years, the world will have recovered from the debt problems and with the increasing wealth of China and India, agribusiness would be the next big HIT.

Rather than buy gold we can invest in Market Vectors Gold Miners ETF.  It has a low expense ratio of 0.53% and invests in gold mining companies such as  Barrick Gold Corporation, Newmont Mining Corporation and Goldcorp  Inc. As paper currencies devalue, gold mining companies will appreciate due to their assets in gold. Now that gold has dropped  to US$1,640, off its high of US$1,800,  this could be a good time to invest inn gold mining companies.

I am not promoting Market Vectors ETFs and don't even know how we can buy them since they are a US based company .I am just using them as an example of low expense ratio ETFs that invest in companies with solid long term assets such as agribusiness and gold. You can look for other similiar ETFs to invest in as I am sure they Market Vectors are not the only one with ETFs in oil , gold and agribusiness.

The final recommendation is Market Vectors Oil Service ETF. This ETF invests in companies that service the oil industry such as Halliburton, Schlumberger and  Baker Hughes. If you think oil is getting scarce and if you believe that oil production has peaked and there is a need to look for new oil fields in areas that are hard to drill, oil service companies will be a good bet.

These three recomendations are not instant hits but safe bets that in two to three years time, may give you more than 10% annualised yield!  These are "hard core" companies that will not go broke, or be over-leveraged because of speculative investments. They have good residual value regardless of the market outlook. The three sectors are in food ( we need to eat) and energy ( we need to keep our homes warm or cool and our cars running!). They are the basic necessities the world needs. Gold is a hedge to protect against rapid inflation or devaluation of paper currencies.

Geopolitics and Regional Currencies

The new weapon is currency, This is the new WMD that could have vast impact on a globalized world. The Cold War has not ended but has morphed into a war fought with money, energy and commodities. Indeed a top general from Europe forecasted that Third World War will be fought over water. Wars, whether hot or cold, are about countries trying to protect themselves and gain advantages over other countries. That is why we have trade pacts and G7, G20, ASEAN and all manner of meetings between heads of states. Each country tries to position itself to gain by forming blocs of all kinds.

Five major players are in this competition . USA, Europe,BRICS, pro-USA Middle East, anti-USA bloc. Each party is in the competition for survival. USA and Europe faces large and growing unemployment and massive debts. BRICS wants to protects its reserves especially US Treasury Holdings and want to improve living standards of its people . Oil rich Middle East has declining oil outputs and may fall back on its reserves to sustain its lifestyle. Anti-USA ENTITIES want nothing more than the collapse of USA or a toothless USA.

In simple terms, it is a battle between the haves and have-nots. The have-nots are countries with massive debts and need to continue to borrow .Like drug addicts, they cannot face the withdrawal pains of not having easy either by borrowing or printing. The haves are those with large reserves , lots of which Is in US dollars which faces steady devaluation. Both parties are locked in a fatal embrace and this year will see a more rapid unlocking of this embrace.

The most obvious unlocking is to stop using US dollar in international trade. Countries have SWAP agreements which enable them to trade using a regional currency. Four regional currencies may appear, the Russian ruble, the Chinese Yuan, Euro and the SDRs of the IMF. Japan is too fearful of the USA , it's political leaders too weak and fragmented to be a regional currency.
Russia will try to persuade Ukraine, Central Asia and Eastern Europe to use the ruble. China will corner Africa and Latin America and even Middle East to use the yuan or the SDRS. Euro will continue to be used by its member states. There already exists various SWAP agreements to allow trade between different currencies without the US dollar.

What this means is that trillions of US dollars will go back to America causing high inflation.It is like a man who eat excessively but his friends get fat , not him. The more he gorge himself, the fatter his friends became. He enjoys all the pleasures of eating and his friends suffer from its effects. Imagine that one day, all the fat accumulated ny his friends suddenly returns to this glutton. Imagine the impact on the glutton even is 20 percent of all fat accumulated on his behalf by his friends is returned to him! That glutton has a name.Hebis called America and his friends are called Japan, China, Russia and Brazil.

Most of these arrangements will be done in secret or with little publicity. We don't get to read it or even understand its importance as the world media covers US presidential elections , Euro debt crisis and the Arab Spring. But momentum is slowing building and like the bamboo, regional currencies suddenly become the talk of the town. It won't be a global catastrophe except for those with US dollars, but there will be confusion by idiots who cannot envision a world where US dollar is no longer the world's reserve currency.

It is good for the world even for America. Take the glutton example. Isn't it better for each country to face the effects of own monetary policies rather than defer the bad effects by temporarily transferring it to others? Not being the world reserve currency will impose fiscal discipline on American politicians who seem to think that it can print and borrow money ad infinitum.

Investors who understand the above stands heads over shoulders above those who blindly follow trends and fashion based on the assumption that US dollar wil be strong as always.

2012 The End of Paper Money

World war 3 has begun but few people recognized it because it is a war not fought with guns and bombs but with currency manipulations. In a world with a shrinking wealth pie, Government scrambled to keep their economies competitive. Sadly, rather than look at long term solutions, most Government goes order the quick fix , which is to devalue their currency. A country exports more when it makes products that are desired by the rest of the world. China produces low cost goods at rock bottom prices by having low wages, ignoring pollution and seizing peasant lands for peanuts . Germany produces expensive quality goods likes its BMW cars through design and manufacturing discipline. But a country with high wages and not enough quality goods and services will end up earning less. This is not bad as lower earnings will result is lower wages and eventually the country will be competitive again.

The problem is the citizens cannot take the pain of earning less . To make up for the deficit in export earnings , the Government spends more. Everyone is happy as the gravy train continues to roll. The problem is that Governments borrow or print money out of the air to sustain the increased expenditure without raising taxes. Raising taxes would mean the people have less to send which is what the Government wants to avoid! But for the time being it is party time until Government either can no longer print money or borrow .

They cannot borrow because lenders are too nervous and believe the borrower would not be able to pay them back. This is amazing as we are not referring to an individual or company but a Government. This lack of trust means lenders are willing to lend only at high interest rates but high interest rates mean the Government would be even less likely to repay debts. This leaves the second option of printing money. Unless the currency is used outside the country, the printed money would return to the country causing inflation . Inflation is when too much money chase after too few assets.

Inflation is political dynamite where there is a large section of the population who are poor. Food prices goes up and the poor starts to protest as they find they can afford less and less food. When a country is awash with money, the rich can borrow more to invest in stocks and properties. The rise in stock and properties benefit the rich while the poor earns the same but has to pay more for food. From China to Africa, political instability is one of the side effects of inflation especially when it is not matched by rising wages at the lower end.

Even in America, the Occupy Wallstreet movement is a protest by the average America against rising cost of living. The US Government wants China to revalue the yuan upwards but this will ake imports more expensive. When before there is a choice of the more expensive locally made product or the cheaper imported product, there is no choice for the Americans since most of the consumer products they want are imported. A rising yuan will increase the cost of imported goods which means inflation will be higher. The American will have to pay more for his clothes, shoes, computers and TVs. They will be unhappy and will express their unhappiness at the coming Presidential elections.

There is no short term solutions and in democratic countries where elections are held every four years , no politician wants to commit suicide by adopting painful long term solutions. So the money printing and the debasement of fiat currencies on a global basis continues until one or more countries get knocked out. Greece for example cannot continue its party since it cannot borrow excessively anymore. America may find that quantitative easinf increases the cost of living and becomes politically untenable. I think the world will continue to debase paper currencies as this is the only option left for Governments.

Fiat Money

Wikipedia defines fiat money as money declared by governments to be legal tender and are issued without any backing of state assets. All national currencies today like the US dollar, Euro and Singapore dollar are fiat money. Many people still believes government cannot print money and must have equivalent amount of gold to back up the money it issues. On Augst 15, 1971 the US government under President Richard Nixon terminated the convertability of dollar into gold. The Bretton Woods systems officially ended and the US dollar became a fiat currency backed by nothing except the promise of the Federal Government!

Fiat money is paper money with no intrinsic value. It is not backed by gold or silver only by faith in the issuing authority. Government issues bonds which are accepted by banks as if it were a genuine tangible asset or an actual deposit. The holder of a Government bond believes he has a claim on a real asset when in fact there are more claims outstanding than real assets! Fiat money offers an easy short term solutions to Governments who spend more than they receive in taxes. Just print the money by issuing Government bonds.

The US Government has this year to issue $2.35 trillion as Treasuries bonds. China and Japan used to buy huge amounts of these bonds but of late they have reduced their purchases and the amount of Treasury bonds has increased by more than what these two and other countries can buy. The Federal Reserve has stepped in to buy these Treasuries! On 4 Nov 2010, the Federal Reserve has said it will buy an additional US$600 billion of Treasuries. Where did the Federal Reserve gets the money or assets to buy these Treasuries? Amazingly it is conjured out of thin air as Congress has given the Feds the power to create money out of nothing. This has created huge amounts of money and in order to maintain exchange rates equilibrium, other countries has also created fiat money to offset this huge increase from the US. The world is flooded with money which is one reason why assets are increasing in price from commodities like gold, silver, oil to properties.

This exploding US National Debt has serious ramifications on the world's economic stability and asset prices. Investments is not limited to a particular share or even how a country is run but globalisation means we have to understand how much fiat money Governments in USA, Europe, Japan and China are creating. Fiat money will eventually lead to massive inflation which devalues money and increases the cost of assets relative to paper currencies.

What to make of sovereign debts

I was told that developed countries in 2009 issued US$12 trillion worth of bonds. It is hard to imagine what this $12 trillion means. Sometimes numbers are so large that they become meaningless because we simply cannot grasp what they mean. At US$1,100 per ounce, one trillion USD buys 25,000 tons of gold. Well 12 trillion buys 300,000 tons of gold! But this comparison is meaningless as most of us do not deal in gold except for a few petty grams of gold trinkets here and there. Let us put this 300,000 tons in perspective. The annual gold production from mines is about 2,400 tons . Developed countries have issued money worth 125 years supply of gold in just one year!

The value of gold can be seen from this simple example. Gold supply is 2400 tons per year but money supply in just 2009 is equal to 300,000 tons or 125 times the annual gold output from all mines. If paper currencies from developed countries multiplies 125 times faster than gold , what do you think will be the value of gold relative to paper currencies?

Interestingly this time the debt is not issued by developing countries but by developed countries with matured economies and presumably run by matured finance ministers. This incredible amount of debt will mean either the countries have to increase taxes, reduce spending or simply print more money. The last alternative seems to be politically the most attractive. When countries issue fiat money in large quantities, inflation will rear its ugly head.

Here is what I believe will happen . Asian currencies or those countries will less debt will have their exchange rates increased relative to those countries with huge debts. Some may think Asian Governments will keep their exchange rate low in order to remain competitive but to do so will be to invite inflation into their own countries. The only way to retain an exchange rate is to follow your neighbours. If the print money, you simply have to follow suit. There will be a period of confusion , of fear but eventually everyone will settle on USA dollar being on par with a Singapore dollar and one Sterling pound is below one Singapore dollar. It is basically a simple arithmetic equation. The more money one prints, the lower the value of that money!

China will at last increase the exchange rate of the yuan vis a vis the US dollar when she realises that she will remain competitive even though the yuan appreciates 50% or even 100%! Manufacturers in USA and Europe are ten to twenty times less cost effective than a China manufacturer and so even a 100% increase in the yuan vis a vis the US dollar will not affect China's competitiveness. If all Asian and BRIC countries currencies appreciates in tandem, China's competitiveness will not be affected.

What will happen is that consumers in Asia and BRIC countries will feel "rich' and this will trigger a consumer boom for Western products. What happens is an exchange of goods by different sets of consumers. Low and middle class Americans and Europeans will buy cheap goods from China while affluent Chinese will buy luxury goods from the West. There will be more tourists from Asia visiting Europe and USA and hence a more equitable world economy will ensue.

Now it is like a person having a severe tummyache. He needs to vormit out the poison in order to feel better. Asia must be brave and accept a higher exchange rate for future stability and not be fearful that higher exchange rates will make their exports uncompetitive. Get the poison of low echange rates out of the way. My wife bought a rechargeable torchlight from China for S$2.00. There is absolutely no way any one in Europe or USA can make that torchlight for S$4.00 or even S$10.00. So let us not worry about high exchange rate and allow our currencies to appreciate and enjoy life! We can have cheaper US steaks and French wine so let's be sensible and do what needs to be done

Is gold a better investment than property?

In 1970, the price of gold is US$34.94 per ounce. Today it is around US$1120 per ounce. This is a 32 times increase since 1970. Imagine you had bought a house in Henry Park , a good district 10 area in Singapore for S$70,000 . Today it is selling for S$1.2 million . You think it is a fantastic investment seeing the price goes up from $70,000 to $1.2 million. In 1970, one US dollar buys $3.06 Singapore dollars. Gold price of US$34.94 is therefore S$107. Today the US dollar is 1.40 and one ounce of gold cost S$1,568.

$70,000 divide by $107 gives 2,222 ounces of gold and this is the amount of gold we get in 1970 for S$70,000. Today S$1.2 million divide by $1,568 gives us 2,987 ounces of gold. This is a miserable 34.4% increase after almost 40 years! That is very poor 0.74% per annum increase over a period of 40 years. Thus while in Singapore dollars, we see a decent 7.36% increase per annum , when we look at the price in terms of gold, we see a miserly 0.74% annual increase. THIS MEANS THAT THE SINGAPORE DOLLAR HAS DEVALUED SIGNIFICANTLY OVER THE PAST 40 YEARS!

Singaporeans who are estatic about their properties and the gains they make should recalculate their value in terms of gold. Gold it seems is a very good long term investment. If we use to buy gold with the $70,000 in 1970, we will have 2,222 ounces. Selling the gold at S$1,568 per ounce will get us S$3,484,096. If instead of buying the terrace house at Henry Park, and had he invested in gold, he would reap earn a huge S$3,414,096 in capital gains. Of course during the period the house could be rented but still the rent would not cover the difference of S$2,284,096.

If gold touches US$2,000 per ounce, or S$2,800, then S$1,200,000 will buy even less gold or a mere 428 ounce. If we sell the house for S$1.2 millon, it means we will in fact be taking a hefty 80% hair cut from our investment in terms of gold. There is a psychological factor here. Few people had invested in gold but most adults would have at some point in their life ad bought or considered buying properties. Today that same house in Henry Park that sells for S$1.2m cannot possibly be sold for S$3.4 million. If we ask S$3.4 million for a 2,000 sq ft terrace house, we will be laughed as mad or totally unrealistic in our expectations. There is less resistance to buying gold at US$2000 per ounce as compared to buying that house for $3.4 million.

Gold mania is far more possible than property mania. Foreign investors cannot buy landed property while there is no restriction for anyone buying gold! Therefore as an investor now perhaps is a good time to invest in gold.

Fundamentals will prevail

The market has rallied and people are optimistic about the greenshoots. But what about the blackshoots which are the opposite to the greenshoots? GM has filed for bankruptcy and the new GM will mean closure of some factories and the loss of thousands of jobs. In any other time, such news would have a negative impact on the US Stock market. But it seems some kind of immunity to bad news have set in and the fact that the US Government has stepped in to "rescue" GM is now treated as good news.

GM is like a sick old man and pumping full of vitamins (money) is not going to revitalise the company. Thousands of managers, supervisors and those who made GM the way it was, remains with the company.Will they change their way of working, will they be suddenly more cost conscious, more creative and more efficient? Possible but very unlikely. They need a boss like Jack Welch , or someone even tougher than Jack to shake up the management and replace the management layer with fresh blood. The fact that no private investors are willing to jump in and take over shows that they know one cannot revitalise a sick old man. With the US Government, union and bondholders being major shareholders, I can imagine how impossible it would be for the board to operate!

With GM , AIG. Fannie Mae and Freddie Mac, the US Government has ended up as owners of large corporate entities. Running a company is like a Viking ship. You need strong and forceful leadership to ensure everyone pulls in the same direction. The US Government cannot provide this kind of leadership and the end result will be a slow decline to lower productivity and even higher losses. Government owned companies in the past has never performed so why should it be different this time around? Britain used to nationalised its major industries and have learned to let them go. The best thing is the hardest to do. Let them all fail and let the marketplace adjusts itself. Failure is not necessarily bad. It opens up opportunities for smaller firms to move into the space vacated by these sick giants. Smaller and more efficient firms will gain market share and in turn create more employment.

The impact of GM closure of factories will have greater impact especially when the number of jobless is already high. The focus seems to be on minimising the impact of negative events such as managing the bankruptcies of GM and Chrysler. There is too much of an eagerness to return to the good old days of double digits return on all sorts of investments. There is a need to reduce consumption, to increase and encourage savings. Interest rates should be high to encourage more savings so that these savings and not money created out of thin air by the US Goernment can be used to reinvest in businesses. If a person lost his savings in a bad investment, he should start to save again to rebuild his nest egg rather than continue spending.

The approach should be bottoms up. Take care of the consumers and businesses will take care of iself. Now it seems the mantra is take care of businesses and it will take care of consumers! The consumer must comes first. He must learn to save more and spend less. Saving more will rebuild capital that America so desperately needed. To keep interest rate low is to punish the consumer. Any business that solely relies on low interest to survive and compete is not a healthy business. It should be able to make money from its equity capital and not from loans from banks. A company with an equity capital of $100 million and makes $10 million profit is earning 10% on its equity. If it borrows $100 million and makes $10 million, its return on capital is hlaved to 5%.
The policy of keeping interest rates low to help businesses is flawed. Higher interest will encourage more savings and some of these savings may end up as equity investments which means companies need not even pay interest since it is equity capital. Without savings, consumer have no money to invest in shares and companies have to revert to the more expensive alternative of borrowing.

The huge amount of debt incurred by US Government and the huge amount of printed money it created will come to haunt it in the years to come. Future generations of Americans will find they have to pay more taxes and suffer a lower standard of living. America will no longer be the consumer capital of the world. It will behave like the son of a rich man who has gone bankrupt. There will be years of denial and Americans will continue to hope and believe that its former glory days can be restored.

America has one trump card up its sleeve. It can spend less on its military. Under President GW Bush the 2009 defence budget is US$515 billion. This is ten times higher than Russia's defence budget. America can trim its defence budget to $200 billion and still spend many times more than any other country. It can save trillions over the next decade if it is willing to pare down its military spending. When Obama starts to reduce the number of trrops stationed overseas, troops not only from Iraq but Germany (56,200 soldiers) ,Japan (33,122 soldiers) and Korea(26,339) soldiers, we will know that they are cutting the defence budget out of sheer necessity. All empires end because they did not have the financial resources to maintain their massive armies. The fall of the Roman Empire is because it could not maintain its soldiers to defend itself. This reduction in military spending will give America the space to recover economically. To maintain its huge military bases overseas is like a bankrupt rich man who insists on keeping its mansions in ten countries.

The fundamental of economics is that money cannot be created out of thin air without long term consequences. Sure there may be no short term consequences but in time, the consequences will be felt. To maintain a huge defence budget in the face of its current huge budget deficit is not to face reality . We will watch and see if the Obama's administration has the courage to face reality or prefers to believe in Hollywood's kind of miracles.

The true cost of fiscal stimulus

G20 leaders have decided to throw money at the current financial crisis. As political leaders, they cannot risk not doing anything. By throwing money at the problem, they hope that they can remain in power until the next election. It is politically sensible thing to do. But will it solve the problem? The answer is a simple no because what it means is that future generations will have to pay for the runaway spending of this generation.

Few people understand the concept of money. Money is stored energy and effort. When you work hard and earn money, the money is for the effort and energy you expended in some activity that is of commercial value. You in turn spend that money to obtain the fruits of someone's else effort. When you buy a loaf of bread, you are paying for the effort of the farmer who planted and harvested the wheat, the truck driver who brought the wheat to the factory and the workers who converted that wheat into bread. You exchange one form of labour for another.

There when money is created out of thin air, two things happen. First one either let the money depreciate or one has to pay it back with interest. Letting the money depreciate is a shrewd political move as consumers are often unaware of the effects of inflation. They are happy to learn their house has appreciated from $500,000 to $1,000,000 but does not know that a loaf of bread that used to cost $1 is now $3! The inflation does not happen overnight but fortunately for politicians a couple of years or more . By then who knows who is in the seat of power?

Paying back with interest is less palatable since someone has to work and expend energy and effort to repay the loan. When money is borrowed by the Government , it has to pay it back via taxation or otherwise. Money is created by the Central Bank or Federal Reserve Board ( out of thin air) and then loaned to the Government. This means energy and effort is borrowed and must be repaid from future energy and effort. So somewhere along the line, someone has to work harder to pay back what was spent earlier! If I am living in the UK or USA, I would consider migrating to a country that has less debts because somewhere, somehow , I need to pay it back. The Government does not work to pay back its debts. It taxes the people to redeem its debts.

It reminds me of past kings and emperor who builds magnificent monuments at a cost of losing their kingdom. There is only so much energy and effort and so it it is used to build monuments, it cannot be used to train and sustain an army, feed its people better and so forth. This borrowing or fiscal stimulus is akin to an emperor building a huge monument. The country will become poorer for sure. Its roads will show signs of wear , its schools will become shoddy, universities will not have the latest laboratory equipment and even its army will be less well equipped.

Leaders of those countries using financial stimulus will have to start cutting back on other programs. Fortunately for the USA it can and should cut down on its military expenditure. It can remain a world military power if the next 10 years it does not have new fighter planes, new stealth frigates and new aircraft carriers. It can bring its soldiers back from Germany and Japan. Goodness gracious World War Two is a thing of the past. Overall infrastructure will see signs of decay and wear. In the past Europe was the OLD Country and America was the NEW Country. In ten years time, China will be the NEW Country and America together with Europe will be the OLD continents.

Don't think of money in terms of share prices or jobs but in terms of energy and effort and one will be able to understand where it will eventually all leads to!

Will Obama's stimulus package save America?

Let us look at the population in the USA. It stands at around 305 million. 25% are under 18 and that leaves 229 million. 12.5% are over 65 and can be considered as retired. The number is now reduced to 190 million. Assume 10% of the population are mental, have a disability which prevents them from working, are in prison or unemployable for one reason or another. That leaves a total of 160 million adults.

The stimulus package is 800 billion which divided by 160 million is equivalent to giving each working adult $5,000. The average salary for an American is $45,000 . The stimulus package includes infrastructure projects and subsidies to State Governments .About $500 billion will go direct to the people. Assume the unemployment rate goes up by7.5%. Out of 160 million, that is 12 million workers and multiplied that by the average salary of $45,000, the amount comes to $540 billion that is lost because of unemployment. Thus the stimulus package is more or less roughly equal to the loss of income for those who lost their jobs.

But the key problem is that many Americans borrow to spend. The average American with a credit file is responsible for $16,635 in debt, excluding mortgages, according to Experian. (Source: U.S. News and World Report, "The End of Credit Card Consumerism," August 2008).Total U.S. consumer debt (which includes credit card debt and non-credit-card debt but not mortgage debt) reached $2.55 trillion at the end of 2007, up from $2.42 trillion at the end of 2006. (Source: Federal Reserve).Divide by 160 million working Americans, that means each working adult has an average of $16,000 consumer debt EXCLUDING HOUSE MORTAGES!

Now that the borrowing has dried up, spending will drop even with the stimulus package.The latter is just enough to counter balance the loss of income of the increased number of unemployed.There is nothing to replace the spending that dries up because of the credit crunch.
There is only one way to stop the pain and that is allowing consumer debt to start again. My friend who just returned from America was amazed to see TV commercials asking consumers to buy now and pay back two years later.Perhaps the only way is to allow easy credit and resume the borrowings of the past decades.

But now foreign countries are becoming wary of the US dollar. US Treasury bonds will be avoided once everyone sees that debt is going to balloon to even more unimaginable proportions. There are two ways to sustain debt. One is to borrow and the other is to print more money. As the former becomes more difficult, printing money becomes the only solution and the result is a colossal drop in the value of the US dollar versus gold and other more stable currencies.

If Obama risks his political capital on the stimulus package, he will definitely ends up as a one term President. The solution is very painful. Banks must fail and be taken over by corporate raiders to start anew. Bankruptcies will purge all those companies that are not competitive or in the wrong industry (eg pampering people on luxuries ). People have to downsize their homes, their cars and their life styles. People have to be so frightened that they stop borrowing to spend. US companies must start to become competitive again and Americans will have to join the rest of the world in slogging it out just to make ends meet. Thrift becomes a household word and good old fashion work and save atttitude becomes fashionable again.

You cannot be a virgin twice

12 January 2009

Governments the world over are hoping for a return to the good old days. But those days are gone, vanish and kaput especially for the USA. The great bull run funded by easy and almost free money is over. Remember the dot com crisis where profits does not matter and all it takes is an internet idea and voila, your company is worth millions. The dot com balloon vanished faster than it came. Profits does matter and this is fundamental investment logic. You pay to buy shares in a company for its future stream of profits. If there is no profit or only the possibility of profit, then you are throwing away your money investing in a dream.

Likewise good old economics will say that debt matters. You cannot keep borrowing forever and ever. For three decades or more, the USA have been a borrower nation. The Government borrowed, the consumers borrowed, the hedge funds companies borrowed and so forth. It seems that borrowing has become a permanent way of life and some new rule of economics have been invented. So the new paradigm in investment is simple. You cannot borrow ALL the time. You can borrow to invest, to create new services or products but you cannot borrow to spend ....not all the time. So with borrowing grounded to a sudden halt, the borrowers are made to face reality which is they can only spend what they earn. Having known the horrors of excessive liquidity , the financial institutions have learned that money must be lent prudently. The banks in particular the investment banks have lost their virginity in an orgy of unbridled debt and mind boggling leveraging.

Now liquidity is tied to financial engineering. The latter is the twin sister of debt. Without huge debt and excessive leveraging, financial engineering would not be able to make the spectacular profits it made in the past decade. The good old days of thirty year old making a million in salary and bonuses by simple trading and leveraging are over. Now it is back to basic which means money is earned through either the making of a product or the provision of a service. Financial engineering neither makes a physical product or a necessary service. To be blunt, it is gambling in a more sophisticated way. Now that casino has gone bankrupt. The virgin has become a whore and there is no going back.

Obama is asking the Americans to go back to old fashioned ways of earning money. Building roads, repairing infrastructure, designing alternative energy solutions and so forth. But the Americans have long relied on immigrants to do its heavy work like road building and other construction work. Alternative energy requires graduates in Science and Engineering and a high degree of post graduates students are foreigners. He is asking Anericans to forget about baseball and Hollywood and go back to boring subjects like Science and Engineering. Goodness who wants to be an engineer when there is the dream of earning instant millions by becoming a Hollywood star. The American Idol is popular because it is the Amercian dream. Nobody wants to go back to do backbreaking work or mind breaking research unless they are forced to. That means lost of retrenchments, lay offs, foreclosures until reality sinks in. That reality is we have to work and work hard for our money.

Throwing trillions at the economy won't work if mindsets are not changed. You can go from being an investment banker to a researcher in alternative energy unless you go back to college and pick up some technical qualifications. You will have to wait for five years or more before enrollment for engineering and Science courses pick up when the students realised that having a good technical degree will help them get a job. And enrollment cannot just increased like that. You need more professors, more laboratories and being a lecturer has to become a hip profession. So we should not wait or hope for the American consumer to spend again, like they did in the good old days.

But all is not doom and gloom. USA represents only 20% of the world economy. There is still that 80% out there that does not have the same approach to life. Chinese students are studying hard and millions graduates emerge from engineering colleges in China and India. Yes there will be slow down and retrenchments in China and emerging markets. They have to live without their top customer, the US consumer. In time, they will adjust and a new market will emerge. This new market will cater to the needs of consumer in emerging markets rather than in developed countries. Take tourism as an example. Chinese tourists may prefer to tour the cheaper Asian countries than visit Europe or USA. Asian non Chinese tourists may prefer to visit China rather than expensive Europe. The booming Asian market in tourism does not depend on Americans or Europeans.This is the new economy that will emerge from the Western originated debt crisis.

Asians will design, manufacture and sell to Asians. A new market will developed. No longer will entrepreneurs look to the West for new ideas and needs but they will start top design products that meet Asian needs.For example, today modems are designed for developed countries where telephone lines are short and easily available. In many parts of Asia there is a shortage of telephone lines and so wireless technology has come to the rescue. Phone and internet communications can be instantly provided by installing a wirelesss terminal that communicates with a base station thirty kilometres away. Satellite receivers are ridiculously cheap. Newspaper in developing countries will receive their newspaper via such satellite receivers. All it need is a low cost electronic display or what is now called e-paper. Today it is expensive but what if the manufacturer is making it by the billions? A low cost satellite receiver with e-paper can deliver news cheaply to billions of people from Peru, Nigeria , Nepal, India to China. These will be products designed by Asians for Asians and China, Taiwan and Korea will lead the way. Japan is too enamoured with Western markets to pay attention .

Now e-paper with high resolution similar to printed paper may be years away. But consumers in Asia are more concerned about cost than high resolution. A low cost but much cheaper e-paper may not have a market in USA and Europe but readily accepted by Asian customers who prefer low resolution news to no news at all. Today researchers are only targetting at the Western markets but the new market will provide the global growth. It is when emerging markets start trading, selling and servicing to one another. This is a huge potential market but can only be understood if you live in an emerging economy. I once asked a lecturer from Temasek Polytechnic to ask his students to design a low cost vacuum pump. He could not get Singapore students to do the project for to a Singaporean, $10 is low cost already. He got three students from India, China and Myanmar to design a $2 vacuum pump. This will be a market understood only by those who earn less than a $1,000 a month. To UK engineer earning $7,000 will not understand why a $100 product must be made to sell at $3.

Years ago, the former Prime Minister of Malaysia exhorts his countrymen to look east. Now is the time to starting looking Eastward for investments, for product design, for new markets and new services. The money is already in the East with China, Japan, Taiwan and Singapore hacing billions in their reserves. When these reserves are put to serve the needs of Asians , Africans and Latin Americans, a new global market will be created. Look east, the west has lost its virginity already.

Making sense of the strong US dollar

It makes no sense. US markets are down, housing prices have halved, large well known and supposedly well capitalised banks have to be rescued, US total deficit exceeded the US$10 trillion mark which the Singapore Straits Times wrote is qual to a debt of more than half a million per family in the USA and yet the US dollar is high? To make sense of this currency movement, let us take the currency as the equivalent of shares in a company. If a company is doing well, its shares will go up because each share is supposedly equal to a portion of the value or assets of the company. We should table all the assets in the USA, add up all the shares in all the US companies, add up all the properties and land cost, add up all the gold the Federal reserves have and divide them by the total amount of US dollars in the world. This in essence is what each US dollar should be worth

The constant Federal and Trade deficits for the past decades implies that
the US is spending more , much more than it is earning. Thus the US dollar should have a lower value compared to other currencies such as the Euro which cumulatively have a positive budget deficit . So why is the US dollar strengthening? I believed it has more to do with liquidity than with the actual fundamentals. US banks are not lending money which means there is a shortage of US dollars. And when there is a shortage, the price of that commodity goes up. In this case, that commodity is the US dollars. Secondly US investors and fund managers are liquidating overseas stocks and commodities and converting them into US dollars. There is therefore a demand for the US dollars needed to pay the investors who have sold their overseas stocks and commodities. If a fund manager sold $1 million Singapore dollar worth of Singapore shares, he will want to sell that $1 million dollar of Singapore dollars to buy US dollars and bring that US dollar back into the USA.

This will eventually create a humongous pool of US dollars in the USA but this pool is counterbalance by the fact that banks are not willing to lend . Think what happens when the lending starts again? For each dollar in its account, a bank can lend out $10 dollars. Where will these trillions of dollars find a home? I believed many US investors will be fed up with their own stock market and property investment which will mean they will look overseas to park their surplus dollars. I forsee a huge boom for overseas shares and properties once the economic picture clears and it can be seen that Asia and some emerging countries like Poland are relatively unscathed by the financial turmoil.

When I hear the news report on CNN and CNBC, I often hear commentators comment on the GLOBAL Financial Crisis. Yet Asia is definitely not in the same position as USA and Europe and even with Europe some countries fare better than others. Poland for example is booming even now. Once the picture settles and we know that Asia and some countries are not that badly affected., investors will chase after assets in these countries. I predict that shares in these countries will be selling for PE ratios far in excess of 20. Property and gold prices will soar as investors seek safety in assets that does not depreciate. Gold prices can be expected to exceed US$1,000 per ounce.

What is happening is not so much an appreciation of assets but a depreciation in paper money especially the US dollar. With so much money chasing after limited assets, these assets have to increase in price.The paper money in banks all over the world is like a crouching tiger, waiting for the coast to be safe and clear, before it pounce. Asian stocks, Asian properties, Asian anything will soon be the flavour of the month. There will be a huge plethora of unit trusts touting all sorts of Asian investment opportunities. Investment is controlled by two emotions: fear and greed. Today it is fear that predominates and so the tiger waits. But a time will come when greed will prevail and the tiger pounces.

This is a time to reap a massive harvest for those with the courage to be contrarians.

The Mother Black Swan

Months ago I wrote about the possibility of a Black Swan event for the financial industry. A Black Swan is an unlikely event but with severe repercussions and impact. The melt down of the financial industry constitutes such a Black Swan event. The severity of the credit crisis caught everyone by surprise. It seems no one knows how BIG the sub prime problem is . When the Federeal Reserve bailed out Fannie Mae and Freddie Mac, who are severely impacted by the mortgages they backed, everyone thought the crisis is more or less stabilised.

Then Bear Stern started wobbling and was bailed out by the Federal Reserve Board . Then Lehman Brothers was allowed to go bankrupt but AIG started to have serious financial issues and was given $80 billion loans. A more serious look revealed that the credit market was in a kind of seizure and $700 billion was approved by Congress to solve the mess. Central banks got together to lower interest rates and more liquidity was pumped into the market .But stock markets kept on falling, falling, falling.

When investment banks are leveraged thirty times and commercial banks leveraged ten times, there is an absolutely humongous amount of debt that needs to be cleared and eliminated. The Carry Trade has started to unwind as Japanese banks have obviously recalled loans in yen. This is why the yen have strengthened while the high yielding currencies like the Aussie and Kiwis have fallen. The Aussie Dollar fall resembles that of a bungee jump as it was steep beyond belief. There is no fundamental reason to such a steep fall in the Aussie, a country rich in resources , stable government and a highly educated population. It is obvious that many investors have borrowed yen and bought Aussie and now they have to sell the Aussie to redeem the Yen denominated loans. Hence Yen goes up and Aussie goes the other way.

Investors have also borrowed yen to buy shares and this has triggered selling all over the world. No one in his right mind would sell shares at such low prices. They did not want to but HAVE to because they have to return their loans whichever currencies the loans are in. Now assuming the total value of shares worldwide is worth $21Y trillions. Only $Y trillion is bought with cold hard cash .The remaining $20Y trillion is bought with loans, loans which now the banks are asking back. Investors borrowed to buy hedge funds which are extremely highly leveraged themselves. So we have this leveraging upon leveraging. Investors who are leveraged are buying investment products which are highly leverage. The deleveraging process has still some more weeks to go before their positions are unwind .

Central banks seem to see the problem as a credit problem and think that by providing more money at lower interest rates, confidence would be restored . What the Central Banks should do is to follow what Hong Kong did many years ago. The Hong Kong Government went in and buy the shares to prop up the market. Perhaps in time they will recognise this but buying shares seems to be political suicide especially with the Presidential elections around the corner. Shares will continue to fall until the loans have all been redeemed and then the rebound will begin. US and European shares will fall until overseas buyers see value and start buying them up. The first rebound will be Asian shares as they are fundamentally sound and do not have the debt and leveraging issues faced by USA and Europe.

But the Mother of all Black Swan has yet to come. This is the real biggie, the knock-out punch that will floor all but those who have hedge in gold. This is when confidence in the US dollar evaporates. When overseas customers stop buying US Treasuries, or US bonds or even US shares. The Federal deficit needs $2 billion a day. Without this infusion of funds from overseas, the only solution would be to print dollars. The result is extremely high inflation in USA and for a period of time, markets will be even more volatile than what we have seen.

There will be a scramble to find a currency to replace the US dollar. The IMF and World Bank will be expanded to include Asia and will be more reflective of the actual financial strength of each country. Perhaps even majority vote in these two world institutions may move to Asian and Middle East countries for after all they are the ones with the money. He who has the money calls the tune.It will be an irony that now IMF and the World Bank will be assisting developed countries who were previously the ones who provided them with the funds. Now an Asian pied piper calls the tune and it would be interesting to see a Chinese or a Japanese lecturing the Prime Minister of Germany or UK on how to manage his country. The only solution to such a massive crisis is to let the ones with the money decide on how they are to lend to the one who needs the money. The current situation is that the ones in debt are the one who decides how their debts are going to be repaid. China, Japan and Middle East countries are not going to provide loans to IMF or World Bank when they have no control over these institutions.

There will not be a collapse. The world is too sophisticated for that to happen. Central bankers and economist will gather together to find a solution. But it will not be just Western bankers and economists but Asians and Middle Eastern bankers and economists who has to come up with a solution that is palatable to their own citizens as well. A price must be paid for the folly of the past. Just as IMF insisted on strong medicine for the countries in which it provided loans, the same strong medicine has to be given out, this time to Western countries; higher tax, lower Government spending , no agricultural subsidies for farmers and so forth.

China , Japan and Asia will have to find new markets for their products. The emergence of countries like Brazil, Russia , Poland and others plus China's potentially huge domestic markets will take up the slack from the US. After all the US contributes only 20% to the global economy and this can be taken up by the emerging countries. Japanese consumers have not been spending but will be encouraged to do so when their Yen becomes so strong that going overseas and buying overseas products become very cheap. Will Japanese consumer take over from the American consumer? Not totally but together with Chinese, Brazilian, Russian and Korean consumers , they will take up the slack that the American consumers have left behind.

A reverse brain drain will occur when top talents and professionals now flow West to East , increasing the competitiveness of Asian companies. The West becomes a less important market .Already we see this in China where there are products catering solely to the Chinese market.Likewise we will see products tailored to Japanese taste which means smaller products to taken up less space and more functionality as well. The lack of funds by Western countries will lead to Asia becoming more dorminant in Africa and even Latin America.

In time to come , Latin America will become the next Asian tigers. America will be too pre-occupied and too poor to interfere with its southern neighbours. It would be interesting when educated Latinos and Mexicans start returning home from USA to their home countries and start new companies. Many Chinese and Indians have done the same in the past decade. It will be a different world but still a rich world where knowledge will continue to grow and new products , new services will sprout.

The long term value of gold

13 September 2008

How do we make sense of the sudden strengthening of the US dollar and the drop in commodities and in particular gold prices? This article tries to give some logic as to how the long term price of gold is being derived. We will first look at the growth in money supply. How much money is being created out of thin air year after year? I am still amazed that some friends still think that Governments cannot create "fiat" money and that any money created have to be backed by gold. This was abandoned since the early 1970s and Central Banks have the power ot create money at will. So let us look at what some journalists say about this money suppy growth.

This was reported in the Economic Times on 12 Septembr 2008:
BEIJING: China's broad measure of money supply rose 16 per cent year-on-year at the end of August, level with the government's annual target, the central bank said on Friday. Here is an excerpt from the Press Release of the European Central Bank on 27 Feb 2008:The annual rate of growth of M3 stood at 11.5% in January 2008, compared with 11.6% in December 2007.

China has pegged its currency to the US dollar which means that as the US expands its money supply, China has to follow suit. The increase in China's money suppy gives us an indication of the US money supply as well as described in the article below:

Financial Senses University wrote on 28 Feb 2008:
In a story published in July, 2006 by the China Daily newspaper titled “Money supply growth unlikely to slow” we were told that, "the ballooning forex reserve is a major factor behind the dynamic growth of the money supply," by Li Yongsen, an economist at Renmin University of China. "The central bank has to release new money to mop up the excess US dollars in the marketplace and enforce a floating band for the renminbi, which is driving up money supply growth," he said. So we ask again. How can there be negligible money supply growth in the US and 2-3% inflation, when China, a country with a pegged currency to the $US, is experiencing money supply growth in the mid-teens and 6.5% inflation in December?The answer should be obvious.That is what the continued rise in the $US prices for precious metals and commodities is telling us."

FXStreet.com wrote on 31 July 2008:
SINGAPORE (Thomson Financial) - Singapore's broad money supply, or M3, rose 7.9 percent to S$325.08 billion ($239 billion) in June from a year ago, data from the Monetary Authority of Singapore showed on Thursday.
M2 edged up to S$315.70 billion from S$293.61 billion a year earlier.

Prices are dependent on two things. Supply and demand and the value of money. We have often think of prices only in terms of supply and demand. If demand exceeds supply, then the prices will go up. What we have often not looked at is the value of money. There is $X amount of money in the world available to buy $Y amount of assets whether it is gold, stocks, properties or bonds. Over time , on an average basis Y must equal to X. Of course there are different asset classes within Y which may move in the opposite directions but over the long run, when we look at prices over one or two decades, then Y generally follows X. Let us take gold as an example. There is the supply and demand issues. On the demand side gold is bought mainly as jewelry with some industrial uses but mainly it is kept by Central Banks and investors as a store of value. Due to its limited supply, gold tends to hold its value better.

As more and more money is being created, then the price of gold goes up , not because there is a great demand but because there is simply too much money chasing after too little gold. Now gold is not an interest bearing investment and so when stocks and properties are going up, few would want to hold gold. Still over ten to twenty years, gold will show its ability as a store of value. Let's look at how gold retain its value over the past ten and twenty years

In September 1998, gold was selling at US$300 per ounce. today it has dropped to US$763. That is an annual increase of 9.78%. However based on money supply growth ,here is what gold prices should be:
1.If it follows a 16% increase ( see quote on China),: US$1,323.
2. If it follows a 11.5% increase (EU) :US$890
3.If it follows a 20% increase ( my guess for USA): US$1,857

Based on money supply growth rates, gold should be valued from US$890 to US$1857.
Let us go back twenty years to 1988. Gold is priced at US$485. Based on today's price of US$763, that is an annual increase of a miserly 2.29%. Assume different average growth rates in the money supply will show that gold is indeed undervalued:
1. 5% growth in money supply, gold should be US$1,286
2. 7.5% growth in money supply, gold should be US$2,060
3. 10% growth in money supply, gold should be US$3,262.

The recent drop in the price of gold is due to a recent contraction in the money supply and other factors described below.
The Telegraph on 19 August 2008 wrote:
"The US money supply has experienced the sharpest contraction in modern history, heightening the risk of a Wall Street crunch and a severe economic slowdown in coming months.Data compiled by Lombard Street Research shows that the M3 ''broad money" aggregates fell by almost $50bn (£26.8bn) in July, the biggest one-month fall since modern records began in 1959. "

This $50billion is a drop in the bucket compared to the amount of funds available world wide for investments. The drop in commodities and equities is most probably caused by hedge funds liquidating their positions probably due to the credit crunch, the sudden contraction in money supply and a herd mindset. The hedge funds managers that want to bet on commodities going up may not be able to borrow to leverage their positions. The sudden contraction in money supply reduces the ability of fund managers to increase their leverage which means if a large investor shorts or sell, the other investors are less able to balance them out.

Wall Street Journal on 9 September 2008 wrote:
“Hedge funds have delivered their portfolios and become defensive, and are now sitting on a lot of cash,” says Mary Ann Bartels, chief U.S. market analyst at Merrill Lyncht Journal Macro-oriented hedge funds, those that invest across a number of sectors and asset classes, were hit particularly hard in August, a result of weakness in widely-held technology shares and resource stocks.

The $155 billion in cash is equivalent to about 8% of hedge fund assets, according to Ms. Bartels, a bullish signal, for hedge-fund managers do not tend to stay in cash for long. With seasonal factors soon turning in favor of stocks (the last three months of the year are generally among the strongest for equities), investors aren’t likely to remain on the sidelines for long. “They’re going to want to participate to boost their numbers,” Ms. Bartels says.

The Wall Street Journal Market Watch on 29 August 2008 wrote:
"Three unidentified U.S. banks held 86,398 short positions, or bets that gold prices will fall, in the COMEX gold market as of Aug. 5 -- 10 times more short positions than a month earlier, a government report showed.The report by the Commodity Futures Trading Commission, which regulates U.S. futures markets, also showed short positions held by three U.S. banks in silver futures had increased more than four times during the same period." The data in the bank participation report is so clear and compelling that it is hard to conclude anything but manipulation," said Theodore Butler, a precious metals analyst, in a note.

The sudden jump in short positions coincided with a slide in silver and gold prices, which fell $12.30 an ounce in July and another $89.20 in August, their biggest monthly loss since at least 1984, according to Factset. Silver has slumped more than $4 an ounce in August, also the biggest since 1984. As for the banks involved in the recent short selling of gold, they are only market makers, taking orders from large money players, such as hedge funds, said Jeffery Christian, founder of commodities research firm CPM Group. "What you have here is the footprints of hedge funds exiting the commodities markets en masse," said Kitco's Nadler.

Bullion Vault on 14 August 2008 wrote:
IN THE WEEK ENDING the 25th of July, a decrease of €578 million in "gold and gold receivables" – reported by the European Central Bank – reflected the sale by two Eurosystem central banks roughly equal to the sale of just over 30 tonnes of gold, notes Julian Phillips of the Gold Forecaster.

The above articles seem to indicate that the drop in gold prices are caused by hedge funds exiting their positions and Central Banks selling of part of their gold reserves coupled with a contraction in money supply. But these are short term events and eventually $X and $Y has to come to some form of equilibrium. THE PRICE OF GOLD WILL BE DETERMINED BY ITS ABILITY TO HOLD ITS VALUE AGAINST PAPER CURRENCIES.

If the US dollar reverts to his previous exchange rate at the beginning of the year, gold will rise to US$806 based on this devaluation of the US dollar alone. However if the money supply growth over the decade is factor in, gold could easily exceed the US$1,000 mark. With the current Federal Deficit in the US , the poor performance of its economy, the large household debts, the depreciation of the US dollar is inevitable.

Gold has reached its fair value

Gold is a store of money and so is paper money. The one exception is that gold has a limited supply while money can be created at will. Many people still think that money is somehow pegged to gold and that Government must have some gold to back up their currency. No the gold peg was removed decades ago and money can now be created almost at will. The key to the possibility of gold reaching US$2000 per ounce is dependent on how much money has been created.

On March 23, 2006, the US Government stopped publishing the M3 money supply data. A reason for doing so is that it wants to hide the amount of money it is creating . The rate at which this M3 money supply increases annually could raneg from a low of 6% to a high of 9%. This means the value of money will decrease. Using the rule of 72, this means the value of the US dollar will drop by half in 12 years using a 6% increase in money supply or just 8 years if we use the higher 9% figure. Thus when gold hits the US$2000 level, it is not that gold prices have risen but that dollar has devalued.

The well known US trade deficit has hit the US$800 billion level which means they buy more than what they exported. We do not know how this trade deficit is computed and whether services are excluded or not. A printer may be made by Hewlett Packard in China and exported back to the USA creating a deficit . But profits made by Hewlett Packard worldwide will be used to pay for the cost of its staff in the US and so this sort of offset the trade deficit. Assuming that somehow three quarters of the trade deficit somehow returns to the US, it leaves an annual deficit of US$200 billion.

But this is part of the overall debt. The Federal , State and Cities in the USA has substantial debts as well. The Federal Debt at at 25 July 2008 is US$9,528 billion dollars. At a 4% interest rate, it has to pay $240 billion just in interest alone each year! This Federal Debt is growing at the rate of $1 million a minute. Scary though it sounds, the pciture can get worse.According to the Institute of Truth in Accounting, the true federal debt is $55,146 billion of off balnce sheet items are included such as Social Security and Medicare. These are "promises" that have to be fulfil in the coming years!

All the increase in money supply goes to fund these debts. When someone incurs a debt, it also mean the other party has money to spend. When the US Government incurs a debt, its employees would be paid and hence have money to spend. When the US Government spends on buying military hardware, defence contractors make a pile and this money goes to its employees and shareholders. So as the US Government goes on a borrowing spree, everyone is happy and the party continues. The question is when will this party end?

Amazingly even more debt is created by the past housing boom fueled by easy credit .These housing mortages are the no questions asked, 100% loans called subprime mortgages. The two institutions that provide mortgage guarantees , Freddie Mac and Fannie Mae, have provided $4.8 trillion worth of mortage guarantees. They owned half the housing mortgage which puts the total US housing mortgage at $10 trillion. The loans benefited housing contractors, real estate agents, interior decorators, furniture and appliance suppliers and a whole gamut of businesses that benefitted from a housing boom! Now all these money spent and earned have to be repaid, somehow.

US Government may step in to bail out Freddie Mac and Fannie Mae but where does it gets the funds from? It is already in deficit which means it either prints more money, borrow more or do both. The end result is the same, an increase in money supply which will cause the US dollar to devalue over time and increases the price of gold! The price of gold in US dollars is meaningless and perhaps more meaningful to compare it with say a house.

In 1970, a terrace house in Singapore can be bought for S$70,000 and gold prices was US$35 per ounce . Based on an exchange rate of $1.8, the terrace house would cost 1,111 ounces of gold. Today the same terrace house cost $1.2 million and gold is at US$930 an ounce with an exchange rate of 1.36. The cost of the same house in gold is 945 ounces. Thus we see that based on gold prices, the cost of the house has indeed dropped rather than increase! Based on this analogy, we see that gold at US$930 per ounce has reached its fair value based on current exchange rate and property prices in Singapore.

What on earth is CDS?

Many people are anxious whether the sub prime mortgage issue is over. Have all the banks written off their bad debts due to the sub prime mortgages. But the question is partially irrelevant because that is not the only issue facing the financial markets. Credit Default Swaps or CDS is a massive US$62 trillion dollar market.

Credit Default Swaps is like an insurance policy, used by debt owners to hedge, or insure, against a default on a debt. There is no assets or collateral involved and hence it can be speculative.Warren Buffett once described derivatives bought speculatively as "financial weapons of mass destruction." In his Berkshire Hathaway annual report to shareholders he said, "Unless derivatives contracts are collateralized or guaranteed, their ultimate value depends on the creditworthiness of the counterparties. In the meantime, though, before a contract is settled, the counterparties record profits and losses -- often huge in amount -- in their current earnings statements without so much as a penny changing hands.

The CDS market is said to be more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association and is far larger than the size of the U.S. stock market (which is valued at about $22 trillion and falling) , the $7.1 trillion mortgage market and the $4.4 trillion U.S. treasuries market according to Harvey Miller, senior partner at Weil, Gotshal & Manges. The effect of CDS's collapse would be even lower liquidity and signals the end of low interest rates. The higher interest rate would have serious impact on an already declining US economy.

CDS is an unregulated market and is used by banks to cover losses when companies fail to repay their loans. If CDS are priced low, then the bank can afford to lend relatively "risk free" at lower interest rates. Without CDS or higher priced CDS, banks would need a higher interest rate to cover the potential loss on a loan. With a slowing economy, risk to loans will increase and with problems from past CDS issued, banks may be very reluctant to lend with collaterals.

Subprime is about MBS or mortgage backed securities but how much CDS based on MBS has been issued? More curious is who are holding these MBS? In the following weeks, we may hear more about CDS and CDS may be as familiar a term as subprime. So hold on tight, the financial tsunami is on its way

The Black Swan Egg

24 Jan 2008

In my earlier posting, I wrote about the Black Swan which is a super catastrophic event. In this instance, the event is the financial market. The sub-prime mortgage problem is like the Black Swan being pregnant while the market upheavals in the past week shows that the Black Swan has laid an egg! When this egg will mature into an adult Black Swan nobody knows.

The sudden drop and the equally dramatic bounce of the stock market world wide reveals two things. First there is nervousness and investors are looking at the slightest opportunity to sell. Second the world acts fast and nervousness spreads from US to the rest of the world pretty fast. The professional investors often need to stay invested .Perhaps they were the ones who sold off fast when prices are high and they are the first ones to buy back when prices are low. For the professional investors or traders, a fortune is made from selling and buying all within two days.

Professional investors act like a herd. This groupie thinking is what allows them to win over the retail investors. When they start selling, prices were high and because of their selling , prices start to drop. The retail investors start to panic and sell their shares which triggers even further drops in the share price. Prices can go almost into a free fall such as the Hong Kong market which dropped 9% in one day.

When prices are low, the pros start to buy and prices started to rise. Retail investors pick up the scent and followed suit. The suckers are the retail investors who sell low and buy high as compared to the professional investors.

Thus the recent stock market gyrations smacked of manipulation, not a pre-planned strategy but one that uses group thinking among professional investors. They can all smell the same thing. All the pros are waiting for is someone to trigger the selling in a big way and soon the herd follow suit creating a global crisis.

You can fool somebody some of the time but not everybody all the time. There will come a time when the professional investors and traders will be caught on the wrong foot. When they start to buy, the retail investors will not follow them leaving them with the baby in the same way as the banks were caught in thier own sub orime mortgage scheme! This tend will be the start of a long bear market!

But as I said the Black Swan has not arrived. It has arrived in the form of an egg. This egg has not hatched but is a matter of time before it hatches. This year will see more of such volatility ie when the egg hatch, when the Black Swan start walking then talk and when it reaches its teenage years.

The size of the US deficit is growing, like the Black Swan. It is a matter of time when the deficit will reach a level where no interest rates cuts, no increase in liquidity can save the lack of confidence in the US dollar. Notice that after the interest rates cuts, gold move up to US$900?
This is a sign that some investors are moving out of paper currencies into gold.

The US dollar now faces a depreciation problem. Who will want to put money in US dollar deposits when Euro deposits gives a higher interest rates with the added advantage of further appreciation against the US dollar? Initially, the US dollar depreciation will stimulate the markets and all appear to be well. But remember the US budget deficit and trade deficit needs billions to support its voracious appetite.What if it cannot find enough international borrowers to finance its deficits? Central banks will have to move in to buy US dollars until they reach a threshold of pain.

When it becomes obvious to the general population that the US dollar is a sinking ship, Governments will find it politically sucidal to continue to buy US dollars. Several events can trigger the speed at which the US dollar depreciates. High oil prices will mean USA have to use its dollar to buy the oil its cars are guzzling. Oil prices is forcasted to reach $160 per barrel in 2009. Another Hurricane Kratina will impose huge recovery costs in the USA. Or perhaps it can be a prolonged drought accompanied by forest fires. Or escalation of the Iraq war to Iran .

Events aside, the more serious problems are systemic. It is the breakdown of institutions and values. The most basic institution the family is resizing. 50% of all marriages end in divorce.31% of children live in single parent or no parent homes.The education system in the USA is crumbling. 60% of high school students cannot read their textbooks properly. One third of graduates cannot pass basic maths. The Enron , WorldcCom and Tyco debacles reveal corporate scandals on a scale never seen before.

The stock market volatility should be seen against this backdrop of institutional breakdowns in the USA and we will understand why it is so hard to fix.

When will the Black Swan arrive?

The Black Swan is an event that is highly improbable but not impossible. Most swans are white and black swans are very rare. Our lives are gretaly affected by unexpected events . These are very rare but of tremendous importance. We have seem to have short memories of tragic events. World War Two arrived to many people unexpectedly although World War One was just a few decades away. Yet with hindsight ( alas everything seems easier with hindsight) they should have seen the war clouds coming as Germany builds up its war machines.

The war clouds are coming but of a different kind. It is a financial war cloud. Perhaps the Mother of All Stock market collapse is coming. A financial Armaggedon is on the horizon. If you think I am a Doomsday pessimist , look at the signs. The fall in value of the US dollar is a symptom of a disease, the disease is called Overspending. Decades of overspending by US Government and US consumers have created a huge debt bubble. No one will ever believe anything drastic can happen to the world's only superpower. There is only one solution. The USA has to stop spending more than what they earn.

This will affect companies exporting to the USA and countries with large exports to the USA will be affected. This will create new opportunities as well. US MNCs will become stronger than US companies that have most of their business turnover in the USA. Those with high turnover outside USA will recover to become stronger. The USA's share of the world's market is declining thanks to the growth in Asia and other emerging economies. Manufacturers will be affected but not to the degree as Financial Manufacturers.

These Financial Manufacturers are the creators of the sub-prime mortgage problems. They create Financial Products to market to investors. Initially these Products are good , they provide diversity and protects investors against the market volatility. But greed has taken over and Financial Products now are designed to maximise the size of the wallets of those in Wall Street. The amount paid to Wall Street Executives is staggering. Financial Manufacturers unlike Product Manufacturers can create something out of nothing. They are supported by the huge amount of money that is released in to the markets by Governments all over the world. It is this huge liquidity combined with the excesses of Financial Manufacturers that will create a Black Swan event.

What will happen when this Black Swan arrives? Stock and property markets will be the first to fall. Those markets that rose the highest and the fastest will fall the most and the fastest. Jobs will shrink. The Travel Industry will see dark days. More books will be written with many authors claiming they have seen it coming. The Black Swan will arrive suddenly and unexpectedly. Over spending is like taking drugs. You cannot slowly be weaned off drugs by taking less and less each week. You have to stop, totally and completely. US overspending will not stop until the Black Swan arrives. But when will it comes? That is the six million dollar question that some people will pay billions to know. Since I am not yet a billionaire, I can't tell you.

Beware the Black Swan

The Black Swan is a highly unlikely but catastrophic event. Assume you are a pig and for one thousand days a human fed and took care of you. You could conclude based on past events that this trend will continue and you do not see anything that could point to a change in the trend. Each day you are given the same amount of food and bathed at exactly the same time. Same food, same time, trendline is the same. Based on past events, there is no reason to forcast a drastic change. But on the 1001 day, something drastic happen. You ended up as a roast pig on someone's wedding dinner.

In investment, we follow the same thinking as the unfortunate pig. We try to use past events to predict the future. Black Swan events can occur swiftly, with no notice and with everyone taken by surprised. All financial crisises are surprises. If they were not unexpected, they would not have been a crisis as everyone would have taken precautions and hedge their investments. But Black Swans events are not totally invisible. The signs are there but we do not see it.It is how we think that makes Black Swans invisible.

Most people would like to believe that they are thinkers but very few actually think. Consider this puzzle:

You are in a room with two doors. Behind one door is a lion that will eat you .In the room are two men who know which is the safe door. One of the two men always tells the truth and the other always tells lies. If you can ask ONLY ONE of the two men , ONE question, what would you ask to choose the correct door. This is not a trick question like asking the men to follow you and so he will be forced to tell the truth. It is a pure logic puzzle.

We don't think because it is hard work. Try and get the answer to the above puzzle and time how long it takes for you to give up! 5 minutes is about the average time someone spends trying to solve the above before he gives up. Let me assure there is an answer and it is no trick so try hard, real hard.

Thinking is never done in isolation. It is surrounded by events. The events cloud and prejudice our thinking. high end condominiums are now selling for S$4,000 psf. It is hard to imagine that very same condo selling for $1,000 psf. A few years ago, we woudl be crazy to think prices would be $4000 psf and $1000 psf is deemed a high price. So why could the same condo that suddenly shot up to $4000 psf not drop to $1000 psf? List down the logical reasons such as construction costs, income earned, supply and demand and so forth.

Is making money so easy these days? If you are a businessman, a restaurant owner, a retail shop owner, you will know that competition is tough and huge profits are not easy toc ome by. Of course there is the occasional Bill Gates who made billions but even Bill Gates's wealth compared to the TOTAL WEALTH in the world is small. Are thousands making easy money as implied by the story of someone who paid $31 million for a penthouse? Our thinking is heavily influenced by narratives and not statistics. We don't know the statistics behind these purchases. Did the buyer paid cash or he took a loan?

True wealth is when a person buys with cash. Virtual wealth is when he takes a loan to buy. If I paid a $1 million in deposit and borrowed $9 million, suddenly $9m is released to the seller. The seller may take that $9 million and splurge creating a wealth effect but someone actually owes a bank that same amount of money. We are spending what someone has borrowed. The total amount of sub prime mortgages outstanding in USA is US$1.5 trillion or US$1,500 billion or US$1,5 million million. Assuming a super airport costs US$1.5 billion to build, that is 1,000 new super airports! 75,000 people earning US$1 million a year will take 20 years to pay off that amount assuming every cent they earn goes to the payment of the debt.

This is just the amount ONE sector of the world is borrowing. We are just talking about sub prime mortgages in USA. What about sub prime mortgages in UK and Europe? Huge mergers and acquisitions requires billions. In 1998 Daimler Benz paid US$36 billion to "merge" with Chrysler. Daimler is selling away its Chrysler investment at a fraction of what it paid to a private equity firm Cerberus Capital Management. In 2000, America Online paid US$182 billion in stock and debt to acquire Time Warner. M&A oftens ends up in negative territory for the combined entity.

Facts can be very misleading. In one financial report, it says that global M &A will reach an all time high in 2007. Last year it totalled a massive US$2.9 TRILLION. But the report went on to say that this M &A is healthy because companies are using cash instead of shares to finance the deals. But is it cash from profits earned and hoarded or cash from borrowings. It goes on to say that Leveraged Buyout Firms using borrowings have US$1.4 TRILLION of buying power. If we add M&A borrowings to sub-prime borrowings, we reach the US$2 TRILLION mark. That is US$ 2 TRILLION of BORROWED MONEY.

No one really knows how much is the Carry Trade borrowing where investors borrow low yen at low interest rate to invest. Maybe it is another US$1 Trillion. What about Hedge Funds that use leverage to enhance yields. We can see that total global borrowings can easily reach a massive US$5 TRILLION dollars. In 2003, the market capitalisation of the US market is US$14 trillion. With estinated borrowings at 35% of total US market capitalisation, one can say the mother of all bubbles is in the works.

With stock markets at record levels, the lessons of the past are forgotten or explained away. The Asian Financial Crisis will not happen as Asian countries have huge savings. But who is talking about an Asian Crisis? What if there is a USA Financial Crisis and Asian countries find that their investment in US Treasuries is now a small fraction of their value due to the exchange rate between the USD and their own currencies. If we had asked Mr Pig whether he could end up as a roast pig, he would give a dozen reasons why that was an impossible event. It seems the same emotions are expressed when I asked if the US dollar could devalue by 50% or more! Impossible ! No way! Can never happen! Central Banks the world over will never let it happen! Really? The sinking of the Titanic is a Black Swan event. The coming financial crisis is a Black Swan event. Watch out!

The Yen and the Stock Market

The recent dive of the global stock market shocks everyone. Analysts proclaim that the correction is healthy, PE ratios are reasonable and markets will continue to rise. Media focus about the remarks from ex-Federal Reserve Chairman Alan Greenspan who said that it is possible that US will have a recession but that it is improbable. Typical Grenspan's talk that is virtually meaningless and leave you to deduct your own conclusions from the remarks.

One of the primary key to whether markets will crash is not none of the above but the availability of cheap Yen from Japan. In technical jargon, it is called the Yen Carry Trade where you borrow Yen at low interest rates and use it to buy shares or deposit in higher interest rates currencies. It is simple maths. Borrow Yen at 1.5% interest from the banks and put into Australian dollars at 5% and hey presto, you earn 3.5% from the difference. Yen has been borrrow for a wide range of activities to finance stock purchases, buying properties and other investments. It is cheap money that is available in billions.

Where does this cheap money comes from? The Japanese Government wants to keep exchange rates low so that the Yen will not appreciate against the US dollar and hurts exports. Japanese companies sell billions to the US and in exchange gets US dollars. There is a DEMAND for Yen to buy US dollars. This must be countered by a demand for US dollars using the Yen . To do that the Japanese Government buys US dollars and sells Yen. So the equation is balanced at least as far as exchange rates go.

But where do the Japaneses Government gets the yen to buy the US dollars? It is money created out of thin air. In 2003 to first quarter 2004, in 15 months , Japan created 35 trillion Yen which is equal to US$2,500 for very person in Japan. All major currencies have appreciated against the US dollar except the Yen. With such a huge amount of instant money, it is not surprising that the Yen has remained low versus the USD. This unprecedented money creation by the Bank of Japan could be the main reason for the strong growth of the global economy.

The global stock market will not be as sensitive to the US interest rate than to the Japanese interest rate. If Bank of Japan raises its interest rate, and if the Yen suddenly appreciates against the US dollar, it might be the pin that pricks the bubble.

Sounds impossible but think it through!

Imagine all the banks in a country which we call Happy has $5 billion in fixed deposits. The bank keep 10% and loan out the balance of the $4.5billion. There is only $500million that is not lent out. There is a property market boom.There is a surge in property loans and $1.0 billion of new loans is needed. But the bank has only $500 million which it by law has to keep in reserves to maintain the Capital Adequacy Ratio. As all the available money has been loaned out, the banks has nothing to lend. All its $4.5 billion has already been loaned out. There is no money in the bank to lend to its new customers.

This is where the incredible magic occurs. Out of thin air, the Government provide a deposit of $1.0 billion to the bank. The bank then use this $1.0 billion deposit to lend to its new customers who needed the loans to buy property. Amazingly the bank has to pay interest to the Government for this $1.0 billion deposit which is an accounting entry created from nothing. Everyone is happy. The banks earn from the spread between what it pays the Government and what it collects in interest from its customers. Customers are happy since they are able to secure loans to buy their properties and the Government is smiling all the way to the bank earning interest from nothing!

When a recession occurs, there is too much money or liquidity and so the Government takes back its deposit and the $1.0 billion it created out of nothing is withdrawn from the market. So far so good as we are back to zero as far as money creation is concerned. This is one reason why recessions are good for they keep the money supply in balance.

But what happens if we have a boom year, year after year. In the second year, property prices rises and now customers want to borrow $2.0 billion. There is no money in the bank and so the Government repeats its miracle and deposit $2.0 billion into the banks .The banks used this money to loan to its customers. Now there is $3.0 billion of additional money in the market, money which never exists before.

If the boom continues for the third, fourth, fifth and sixth year, one can imagine how much new money is injected into the market. This huge supply of money creates inflation as with more money floating around, prices have nowhere to go but up. The money has depreciated simply because there is so much more money chasing after the same assets.

If initially in the country called Happy there is $100 billion of money. After six years, $20 billion of new money has been created. The total money supply increased from $100 billion to $120 billion. One dollar is now worth 83 cents of the one dollar six years ago. $120 billion times 0.833 is $100 billion. This is how our money gets smaller as the years go by. The main beneficiary is the Government who has created $20 billion from nothing and the citizens of Happy find after six years that their hard earned savings is now worth 17% less than before.

In a nut shell, that is how the modern economy works. The lesson is to put your money in hard assets such as gold, properties and stocks. Never leave your money in fixed deposits. The money will devalue year after year.