The Margin Call Blog

2007 + 5 = 2012

2011-12-31T17:29:00.002+01:00

Some global macro commentaries for 2012. As the equation above states, 2012 is the due date of most of the speculative loans committed at the top of the credit bubble, 2007 - most of them are 5 year in duration. Expect a new wave of corporate defaults in 2012, coupled with sovereign credit stresses and stock margin calls, which do not bode well for the credit market.

2012 will be the beginning of the bursting of the European residential estate bubble as well, when the glut of supplies of the previous years and coming austerity meet raising interest rates and generational shift.

For stocks, forecasting 800 S&P for the end of 2012, I am playing this target and will increase the position the first days of the year (remember 2008). This is a wave target for the next downward phase which is likely to start early in January. This matches well with medium term fair values for stocks, once corporate profit margin revert to long term normal and investor accept more reasonable Price to Earnings ratios in a low-growth environment.

As usual, it is difficult to do any Forex forecast, I just expect some USD strength at the start of the year, after that I expect the EUR to be the winner of the year, especially against speculative currency like the AUD. Market will soon realise that the situation is worse elsewhere than in Europe. Certainly some JPY strength as well until a collapse of the currency later – once again, very difficult to find a tradable timing.

On the government bond front, it is still too early to bet massively on the collapse of US treasuries, wait for the recession being in the social mood again. This is the trade for 2013.

Hoping for lower crude price as well, first so that it could bankrupt the tar sand oil industry in Canada, which is not only an environmental disaster, but an economical one as well. Then as an opportunity to invest in the energy complex at better prices than today – think oil service, drillers, and some small oil and gas companies.

Do not expect too much from central banks this year, and nothing from politicos. Social mood has changed those last two years, a defaulting bank or country is no longer unthinkable.

2011 has seen numerous black swans. Who would have bet that bond vigilantes would manage to tumble the corrupt Italian government and its exuberant leader? Could we see stupidity and corruption being kicked out of our systems? Wishful thinking, but be patient…

As usual, expect the unexpected to happen, think independently and read The Margin Call Blog.

Wishing you a happy new year.

When Stupidity meets Corruption

2011-08-07T10:26:00.000+02:00

This post is a follow-up of the previous one. Recent developments (i.e. in the latest 9 months) have shown that the state of the affairs has not changed.

Southern Europe issues is the first area where corruption is still in full speed. It makes no doubt that Greece, Portugal and the others should default on their debt, and the markets have already assumed a default as regards bond valuation, while banks and investors had one year and a half to get prepared to this issue, whereas on the other hand lobbying continues full speed to influence stupid rulers in presenting them a restructuring as a catastrophic event (this is indeed catastrophic only to European large bank shareholders and to a lesser extend, their bondholders). History is full of sovereign defaults with always only temporary inconveniences.

The latest proposal from the ECB/EC/IMF and all other corrupt institution is to force privatization to guarantee new loans that will support existing creditors. This has a probability of success close to zero, as employee support for this deal will be null and any restructuring to restore profitability impossible.

Ireland case is worse, from a corruption standpoint, as the state was solvent until the bank bailout has been forced on the sake of Eurozone stability. There, austerity is just to protect bank bondholders, while the state solvency could be restored by a stroke of a pen.

The latest phase of Quantitative Easing (QE2) by the Fed is just another example of stupidity meeting corruption. Expected by Fed official as a mean to kick start US economy by rising the price of assets and increasing wealth effect, it has indeed been pushed by the banking cartel as a way to get rid of as much treasuries as possible by pushing them on the Fed balance sheet, ahead of a certain default of the United States sovereign (which will happen whatever path the government will follow, be it through straight debt restructuring or hyperinflation).

On QE2 again, as I understand very well that investors bid up the price of everything, I fail to understand economic agents’ stupidity in resizing the production tool as if the crisis has been forgotten. Increasing workforce and investments in the current environment is pure fallacy. This is corruption on one side, stupidity on the other.

The recent debt ceiling fiasco in the Washington D.C. is the latest striking example of corruption meeting stupidity. Corruption is in the form of republican refusing to admit that a system where the wealthiest pay minimum tax rate is unfair and unsustainable, on the misleading conclusion that rising taxes kills jobs. John Boehner, republican house speaker who is the main proponent of this theory, has the word Corruption written in big bold letters on his face. Stupidity on the other sides is with the politicos who still believe they have alternatives to delay austerity, when there is indeed no choice between reducing government spending and increasing taxes, both need to happen together, and it is not to them to decide but to the market. Expect bond yield to rise as soon as the current stock market rout ends.

Now let us visit the most probable outcome of the current statu quo. As stated in the previous post, corruption - in whatever form it takes – is used by weak systems to last as long as possible. The current system intends to continue growing wealth of a ruling upper class, while spoiling the lower. All the decisions on fixing the crisis were driven by preserving and even increasing accumulated wealth, stored in pension funds, hedge funds, or government and corporate bonds of any kind, which require protecting the bondholders of any institution. All of this at the expense of the producing force. The main problem, and the reason why all of those desperate efforts will eventually fail, is that accumulated debt, at a growth rate of about three times the GDP, cannot be repaid, as it is supported by no productive assets. By altering the market equilibrium, i.e. by increasing prices agents are willing to pay, corruption adds instability to the system. When it will become clear that nothing is sustainable, like stock prices being driven by record company earnings as a direct consequence of economic agent being forced to re-invest and re-spend, one can expect the house of card to tumble. The following bubble to pop will then be government bonds, but certainly later in the current decade.

Corruption always ultimately fails. Political systems on weak foundations fail. When inequities exceed a sustainable level, the system gets toppled and a new system rises from the ashes of the previous one. Which means a likely outcome is a default, something leading to a 30% loss of wealth for the upper class, if not more, with the usual collateral damages.

On corruption and the role of the state

2011-06-03T18:10:00.000+02:00

A lot has been said as regards the 2008-2009 financial crisis. Interest rates too low for too long, lax lending standards, too many economic agent seeking yield at any cost, glut of savings to be invested from oversaving Asia, not enough financial regulation, etc, etc.

However, none has been said on the central factor of the crash – an extensively corrupt political and economic system. Let us be clear – corruption has changed from the good old days of the full-of-banknotes attaché case. Corruption has infiltrated numerous levels of the current ruling class.

First, upper level management of public companies is allegedly corrupt. Those ruling elites have put short term profit ahead of the long-term profitability of the company they have the duty to lead, of course as a way to reap as many bonus out of the shareholders. Putting short-term profit (and in particular as measured by Return Over Equity) first has led to excessive risk taking (think financials), misallocation of capital (think Leveraged Buy-Outs at sky-high price/EBITDA ratios), and stocks buy-back funded by new debt issuance (a way to reduce capital and increase debt-to-capital ratio).

Second, shareholders are corrupt. They have not played their duty of shareholder, which is to ensure that the value of the stock they hold will be sustained by steady cash flows in the future. Corporate governance has been swept under the rug – the first reason being the fragmentation of shareholding. Family-owned corporations, where shareholders have long-term interest in the future of their holdings, are no longer the rule but the exception. How can a pension fund manager working at the 100^th floor of a Manhattan skyscraper have any long term interest in a company he holds shares of, while he will be shortly working for someone else paying him more thanks to his recent performance ? I call this outright corruption – taking short term money in exchange for complacency.

The major attribute is the extent to which the system became corrupt – when everyone is in, why care? How to blame those who followed the trend, while at that time they would have been fired for not doing it? In another way, corruption and incompetence are often borderline different. The Lehman Brothers Holding bankruptcy investigation has shown executive hiding themselves under the shield of incompetence. No one has seen anything coming from the 2006-2007 excesses, and the rest is history.

Last but not least, the political system of our developed countries is corrupt. How could any elected representative have any longer term view when its goal is just that – being (re)elected? How can we trust politicians whose major occupation is to tour the country seeking funds from companies for their next campaign?

I would give the following definition of a developed country – a country where corruption is the monopoly of the upper ruling class, contrary to a traditional developing country where it is more widespread at other levels – think public employees like law enforcers.

Here comes the discussion on the role of the state. A lot has been said on the need for more financial regulation, but none on reforming the current state of affairs. According to me, the State has three duties:

- enforce private property right, that means fight against the law of the strongest – this is the first basis of a capitalist system, which requires confidence in that the proceeds of a venture can be enjoyed by its owner

- provide financing to long-term general interest investment which a single body cannot, either from a risk stand point or a too-distant break-even point – think of critical road and rail infrastructure, fundamental research and more basically, education

- fight monopoly power

Fighting monopoly power means fighting corruption. In a world of believers in the efficient markets theory that tend to a self-balanced state, monopoly power cannot exist. Yet it does, and it is sustained by corruption. Corruption allows ruined business models to survive and prevent what free market enthusiasts call creative destruction – old models replaced by more productive one.

Reforming the system means first taking corruption out of it, which means restoring a balance of power between the lower end and the higher end. And no one of the ruling class will deal with this unless it’s too late – think of the system being toppled or companies with self-serving management being bankrupt.

Some atomic thoughts

2011-04-25T22:31:00.000+02:00

Even before the Japanese (radioactive) dust settles, and considering the similar-sized havoc that occurred in nuclear stocks (reactors designer and uranium miners) recently, a lot of media, politics and Non-Governmental Organisations are already calling for the end of atomic energy following the Japanese nuclear catastrophe. Before drawing any conclusion on the fate of the nuclear age, which would be premature, it is worth noting that the fallouts of the Japan nuclear mayhem can provide some tailwind to some competing nuclear reactor design.

A first reactor design for which a lot of interest can re-emerge is the Pebble Bed Reactor (PBR). This is a relatively simple design where nuclear fuel, moderator and containment are located in single tennis-ball-sized “pebble”, some hundred of thousands of which are needed to fuel a reactor.

Made of some carbon-ceramic materials similar to those found on atmospheric re-entry vehicles, their outer shelf insulates both the fuel and the fission by-product (gas – xenon and iodine, and actinides – plutonium, strontium and others). Any unlikely fracture or melting down of the reactor body that would let escape fuel would rapidly lead to pebble spreading away and the overall reactor would no longer have a critical mass of fuel in it, causing the nuclear reaction to stop. The only source of heat remaining inside the pebbles would be the decay of the by-products which is of a significantly lower intensity.

The coolant of the reactor is usually helium, which has the physical advantage of allowing the reactor to run at a much higher temperature, thus at a higher thermal

efficiency compared to a conventional, water-cooled design, and, more importantly, can not accumulate radiation as it is mostly chemically and atomically inert. Any leakage of coolant would thus be harmless.

This design has another significant advantage in that it is passively controlled. The property of the fuel arrangement, for a reason I do not understand very well since I am not a nuclear engineer, allows for the natural, non-fissile 238 Uranium in the core to capture more neutron as the temperature rises through “Doppler-broadening”, i.e. the increase of temperature increases the frequency band of which the nuclei can absorb neutrons. As a consequence, the fission of remaining 235 Uranium is slowed, down to a higher temperature equilibrium.

To make things simple, the less you cool the reactor, i.e. the less you draw power from it, the less the nuclear reaction delivers power, and inversely.

A loss-of-coolant event like the ones currently at play in Japan has no consequence as the reactor stabilizes to a high temperature where the nuclear reaction is almost stopped.

As from a probability standpoint, the likely aftermath of the Japan catastrophe will be to prove that by design it is impossible to completely prevent loss-of-coolant or loss-of-containment event (we had 5 of them in less than 40 years if you take into account Three Mile Island, Chernobyl and the Fukushima reactors, compared to a design objective of less than 1 per million year), a Pebble Bed Reactor design makes a lot of sense.

Even some more cutting edge design like sub-critical reactors could see revival of their development. In this type of reactor, the fissile material (usually thorium) is in a quantity below the critical mass and cannot thus sustain a chain reaction on its own. It needs to be fed by a source of neutron coming from a particulate accelerator, that, once switched of in case of an emergency prevents any continuation of the fission and limits the production of heat in the reactor.

Being able to pick the winner and loser of the atomic establishment seems, as of today, a pure gamble and I will not enter it here. For sure, what will happen is a reconsideration of a lot of design options (I would be interested to know the stupid idiots who authorized the installation of Fukushima back-up generators underneath the potential flooding limit). Another point is the rise of costs that all operators will face, as well as the financial risk of decommissioning the oldest design.

Global macro update

2011-02-13T16:46:00.000+01:00

With mainstream media about to cheer a double of the stock market since the 2009 near collapse (666 to 1332 on the S&P 500) in the coming days, it’s time for an update.

As of last year stocks are significantly overvalued, unless one considers business as usual and set asides all of the risks the world faces this year. To justify the current price of US large capitalizations, analysts expect Earnings Per Share (EPS) of $87 for 2011 for the S&P500, to be compared $80.72 if one takes the 2010 Q4 EPS and multiplies by 4. Taking this $80 EPS and the last print of the index (1329), one has to pay 16.5 times earnings to buy it.

Expecting a 20% rise in earnings now corresponds to expecting worldwide growth to continue unabated. However 2010 Q4 preliminary US GDP figures, if taken at face value, already indicate US imports are slowing. All of the other components like consumption, investment and exports are strong, but for how long? Investment rise is nothing more than the consequence of the 2009 under-investment period, rise in consumption is the consequence of government spending, either outright or through removing the uncertainties about tax rise.

What about exports? Once again, everyone is looking at China. With already 20% inflation and monetary authorities doing everything in their power to tame the housing bubble, one has to be very optimistic to expect continuous growth there. Industrial production, as indicated by electricity demand, is already down.

Do not forget either that corporate margins are already back to record highs. Any element affecting them, like pressure on wages in Europe (Germany) and Asia, rise in raw material or rise in the USD are not discounted yet.

Last year in my forecast, I was expecting the top of the Earnings to occur on Q2 2010. I am wrong by 3%. However I suspect the next quarter to be disappointing and to be below the 12% rise analysts are expecting. Assuming we have earnings disappointment in Q1, that means in mid-April as they start being reported, this would be a good time to expect a significant market correction (10 – 20%) – although it is likely to happen earlier. Unless the correction occurs and the stock markets continues to grind higher, treasury yields will continue to rise, until the house of cards falls. Remember Bernanke needs a stock correction to justify a new round in quantitative easing before the current one expires. This new round is needed to finance US deficit.

On a technical stand point, all of the elements are in place to indicate the up cycle is complete; there is something like one percent upside potential. Treasury yields refused to join the stock market higher last week, and leading sectors like airlines are lagging behind.

Quarter ending	Quarter EPS ($)
12/31/2011	20.01
09/30/2011	22.42
06/30/2011	22.41
03/30/2011	22.62

12/31/2010	20.18
09/30/2010	19.52
06/30/2010	19.68
03/30/2010	17.48

S&P 500 Earning Per Share and estimates - source: Standard & Poors

Paris Real Estate bubble update

2011-02-13T15:38:00.002+01:00

Just a brief note today on another evidence: Paris residential Real Estate is in a bubble of huge proportion. Nothing new here. A two-bedroom apartment sells for EUR 400,000+, or something like EUR 6,000 per sq. m. People have been rushing to buy ahead of tax credit expiry and to profit from low interest rates. On valuation, nothing new, as this kind of good rents by something like EUR 1,200 per month, delivering after tax, fees and expenses a yield lower than 3%.

What has changed from the state of the affairs is the collapse of the commercial real-estate. Some weeks ago, returning from an early transatlantic flight, I spent some time in the high-end area of the Opera waiting for a train connection. I can tell you there is a lot office space to rent in an area usually occupied by luxury shops, asset managers or consultants. With government shrinking staff and corporation cutting costs in the coming austerity period, the vacancy rate in Paris has just one way to go: up.

For political reasons, the previous administration in Paris had a policy to reduce affordability of Paris residential real estate, mainly by driving conversion of apartments into office space. Following some months or years of office vacancies, a rational expectation is to see this trend to reverse, flooding the residential market. Add to that a vast inventory of unoccupied space hold by speculators that will come to the market as soon as the prices stops risings and you have all of the elements to call for a market top.

From South to North

2010-11-20T19:27:00.000+01:00

Once again, and almost an exact year after a previous similar post, I am writing this one while returning home from China, smoothly flying over Siberia in a big Triple Seven “300ER”. With almost seven hours to go and nothing else more interesting to do (not to mention that the Windows CE-run In-Flight Entertainment of the plane is almost dead) it is a good moment to devote more time to The Margin Call blog (the only blog of Global Macro, ornithology and travel reviews).

This time I spent three weeks and come home with a more thorough overview of the country. In addition to Shanghai I had the opportunity to go outside the metropolis and to Beijing.

As an introductory note, I recommend all of those who are wondering on the China miracle to plan a trip there. A lot of commentators are talking about China from the deformed vision we get from our mainstream media.

A first impression, from one year ago, is that construction seems to have slowed a lot. Of course last year Shanghai was bracing for the expo. Less traffic in the street now, however the subway network has been significantly extended as well. Certainly a slowing of manufacturing. Even the China daily is reporting slowdown in electricity demand which contrasts with official numbers of manufacturing activity on a healthy rise.

In and outside the city, new infrastructures look outsized. While taking future growth into account for infrastructure planning is valuable, China has borrowed a lot from the future. Outside Shanghai, 4 or 6-lane highway are desperately empty apart from some light trucks and motorcycles, and even Beijing airport international departure hall looked desert.

The night train ride from Shanghai airport (a new-built, gigantic railway station looking like an airport hall itself) to Beijing is smooth. Railcars are brand-new, first-class sized with personal TV at each bed.

Travelling from South to North offers lot of contrasts. Shanghai is a vertical city stranded by sea and river (Shanghai means literally “above water” in mandarin) while Beijing (“Capital of the North”) is a flat city spreading along a wide plain on hundreds of square miles. Flat only in the historical downtown as the periphery is rising vertically as well.

In China, the South is lively and noisy. The South is for entrepreneurs. The North is orderly. The North is for administration. The whole city of Beijing is oriented North-South / East-West. One that can see the sun can find its way easily.

There are 6 different wide ring roads in Beijing. Shanghai has elevated highways on top of main avenues - as no space would have been otherwise available.

The Forbidden City of Beijing has to be visited from South to North. Even the Airport has its runways aligned the same way!

Back to economics, in Shanghai, among discussion between Chinese workmates or by reading the local papers, the two major subjects of discussions are inflation and home prices (both of them of course are linked).

As regards inflation, although official numbers point to a 4-5% price increase, the reality is closer to 8%, with wage inflation up to 10% (for those who work in sectors where there is labour shortage – but for the others?).

As for home prices, I heard of people getting money incentives from their company to buy, while on the other side the company (especially state-owned ones) have stakes in the construction companies and developers. Prices in some places seem to have exceeded the RMB 100,000 per sq.m mark, while rents are lagging behind – keep in mind a good wage for experienced people there is in the RMB 10,000-15,000 per month range – house prices are reaching those in European capitals while wages lag behind by a factor of 3-4. Doesn’t sound like a bubble to you? However, newspapers report that home prices are rising at a slower pace. Remember that a bubble needs to have steady price rise to be sustainable – remember what happened in the US when the music stopped.

All of that, together with some feedback I had from foreigner there, is that China (and especially urban areas) is a mature market. This is not something you hear in the mainstream media. Multinationals are starting to look elsewhere to the south-east Asia for growth.

Who are the losers and winners in China? Looking at the number of customers in the shops, Ice-cream maker Häagen-Dazs certainly is one winner, McDonnald and KFC maybe, Starbucks I don’t know, Volkswagen and GM certainly, but surely not Swiss watch makers and other luxury brands (which is one of the reason I think the luxury bubble will pop earlier than anyone expects). Apple is the big absent – not seen a lot of iPhone in the subway (and certainly a lot are fake replicas), many more Nokia and Samsung (yet another reason for betting on the Apple bubble pop) – Apple products are too expensive for China, period.

How to conclude on China’s future? I can repeat what I wrote almost one year ago – certainly a bright future but a bumpy ride. The roasted duck can very well turn into a black swan. The apparent unity of the population and its acceptance of the current state of the affairs (i.e. accept social inequities as long as the living standard of everyone is rising) could very well tumble.

Chinese are noisy, undisciplined (why trying to board a metro railcar before people have stepped down? Anyway they do) and animated by gregarious spirit. Exactly what is needed to blow and then burst a bubble…

Financial and economics considerations apart, definitely, I will enjoy Asia, especially at this season. Walking down the streets in the morning enjoying an absolutely still air under a glazing sun gives a feeling of quietude and harmony.

Returning home, I will miss the 20 meter swimming pool of the Shanghai Mandarin hotel, the breathtaking view of the skyline in the morning light and the Cantonese rice with bacon at breakfast.

And for the last minute of fun, a verbatim of a well-known American commercial:

A full-fare return ticket to China : EUR 2,200

Three weeks in a great Hotel downtown Shanghai: RMB 29,000

A night-train trip from Shanghai to Beijing : RMB 650

A walk along the Great Wall under an autumn bright blue sky at company expense: Priceless

Sell Everything

2010-09-20T22:08:00.001+02:00

When too much is too much, when everyone is on the same side of the trade, when optimism is so blatant, and with divergence everywhere, I do not see any other possible outcome than a harsh correction in the coming days or weeks.

Dow Industrial diverges from the Transports, the Consumer discretionary (XLY) diverges from Financials (XLF), neither VIX, 30Y Treasuries nor AUDJPY made any new extremum.

Moreover, the S&P 500 is at the top of long term down line (see monthly chart), which coincides with the second shoulder from its Head and Shoulder, and it as completed a corrective a-b-c wave of almost perfect proportion (almost c=a), and the AUD/USD pair completed a 5-wave impulse.

With the St Bernanke day tomorrow, the market is making a top just ahead of it.

As usual, the wise investor can buy put options to profit from the ridiculously low volatility, while more aggressive ones can go short outright.

Industrial vs Transports

Consumer Discretionary vs Financials (the two pillar of the bubble)

Volatility and Inverse Treasury Bonds

S&P 500 Monthly, Daily and Hourly

AUD USD is topy as well

Stay tunned for the crash wave. Read The Margin Call Blog, the only blog of global macro and ornithology.

From Black Swans to White Storks

2010-08-23T22:12:00.001+02:00

This post is here to prove that I am not interested only in financial speculation and global macro.

It was one week from now, as a dozen of white storks landed in a field nearby (for the record, this rare event was related by the local paper on the front page – just to prove once more how hollow local papers are here in France, especially in summer time). They were on their way to their yearly round trip from central Europe to the Big South.

However this time, and contrary to beer drinkers being carried to the sun, they were not stuck here because of volcanic dust, an Air Traffic Control strike, or a manufacturer’s Airworthiness Directive relative to their quill feather. Two lasting days of awful weather with almost 4 inches of rain kept them from flying, leaving them wandering in the field like stranded travellers in an airport terminal, sniffing after worms like hungry tourists would after a hot dogs shop.

As the sun went back and the big volatiles took off again with the return of updraughts powerful enough to lift their 8 lbs we did the same in our big, fat Duo Discus glider, my Brother and I. The probability to cross their track was certainly the same as finding a needle in a haystack, however we did it.

They showed up in formation flying with almost the same perfection as a squadron of Mark V Spitfires defending Her Majesty Land during the battle of

England

and we had the rare pleasure of flying with majestic birds, different to the usual swallows or buzzards, familiar with this area of North East France.

A few circles later and they were above us – with more weight per unit area of wing, we had an excuse.

Timber!

2010-08-23T22:11:00.000+02:00

Today market action should be far from reassuring those long stocks (late negative close of S&P, positive close of volatility and treasuries despite having spent most of the day in the red). It seems to be the last time to hedge before the return of rough seas. The market might very well sink by more than 10% in the coming days (fundamentals, technicals and timing tend to concur).
You have been warned. Don't go out without your hard hat, especially if you hear the chainsaws.

To stop deflation, raise interest rates

2010-08-15T12:00:00.001+02:00

To understand where we are today with respect to deflation, let us go back to the eighties. Three factors have played key roles:
- the opening of China and more generally Asia to foreign world
- the parabolic rise in productivity thanks to nascent Information Technology
- the former Soviet-ruled states turning into open, industrial countries

All of those three factors contributed to reduce price of goods and services. The response of the developed world to those could have been two ways:
- compete directly with new industrial entrants by forcing wage deflation
- compensate the lost industrial jobs due to external competition and productivity gains by creating new unproductive activities

Of course, the latter solution has been chosen. The former would have implied debt deflation and the bankruptcy of the agents who piled-up on the sixties-and-seventies era debt. It would have required elimination of unions who would have fought against any attempt to level down the wages with those of the new competitors.
Europe saw reduction of industrial jobs compensated by government jobs, through added layers of bureaucracy, reduction of labour week (which ultimately means fighting deflation induced by productivity gains by increasing unit labour cost, with the disastrous consequence of creating more incentives to outsource the few remaining industrial jobs), and kickstart a consumer and leisure society.
United States has followed the same path while pushing the consumer society to its limits by creating a false sense of prosperity (through increase of value of assets, be they real estate or stocks) so that everyone, regardless of its income, spends, relying on credit. One of the consequences has been an oversized financial sector (in terms of its contribution to GDP).
Just another example of unproductive move on both sides of the Atlantic: the switch to a just-in-time economy relying on road transportation, the most unproductive way of moving goods, with the only advantage of reducing stock, and thus increasing return on equity to shareholders (less capital needed to run a business thus higher return per unit of capital).

This secular shift from productive, industrial economies to unproductive, service-driven ones has been seen in financials as well. Most of the investment has moved from the productive to the unproductive sector (be it government, residential or commercial rear estate debt).

So today we are left with piles of non-paying debt as supported by no cash flow (unlike an industrial investment), forcing the central banks to reduce the interest rates so that their meagre yields can continue to attract investors.
What are the consequences? With the zero bound on interest rates being already exceeded, and no decision taken to address the key issue – that is rising unemployment, now exceeding the 25% mark among the weakest and unprotected part of the population, i.e. the less than 25 year-old, what are the solutions left ? Notice first that any action now will be much more difficult than 20 years ago, now that US debt-to-GDP (the sum of public and private debt) is around 350%.

I am of those who think the only possible way is re-industrialisation of our developed economies. Be it through protectionism (environment protection could be the official reason to impose new tariff from imported goods), the rise in cost of transport (the long term cost of energy is up), inflation and unrest in developing countries which will increase the cost and risk of outsourcing, the late perception that any productive investment in developing country will ultimately profit the local government, not the multinational company at its origin, etc.
Of course this is very bearish for China et al, as any single job created in developed country will result in the destruction of a few in emerging nations, due to the difference in productivity.

Every other sell-side analyst will claim that China will turn into a consumer society itself. An impossible outcome as first today only a small part of urban China is a candidate, and second as it will consume all of the available natural resources. Living standard in China exceeding the US one is pure fallacy, unless US one falls a lot (which it could!).

The transition from today (further push to stimulate an unproductive economy) into the new model (productive investment) cannot be smooth. With low interest rate and no incentive to invest in developed countries (will any multinational or even a SME invest in Europe or US with the prospect of rising taxes and unfair competition from developing countries?), the only game in town, from an investment perspective, is to continue carry trade, which means use artificially low short term rates to continue to bid up the old debt which should be already priced as junk (as no sufficient cash flow supports it).

The only possible way to break the vicious circle is to raise interest rates, so that investors have choice to invest in productive ventures, and are not forced to continue misallocation of capital.
What will trigger this outcome? A string of bankruptcies, social unrest, taxpayer strike, or simply bondholders deciding too much is too much – as usual the timing will be given by the bond market. The only current bubble (apart from gold) is the government bond market, which lasts since the eighties, and has some more time to go before the final burst…

Another day, another divergence

2010-08-04T22:25:00.004+02:00

Just a brief update – the stock market is getting very near its top. And this time it will not be revisited for a very long time. Today we have a new high on the S&P, but no new high on RSI, no new high on AUD/JPY, no new high on financials and no new low on either volatility (VIX) or bonds. With the level of the indices close to major resistances, both from Eliott wave or Fibonacci stand point (circa 1140 on S&P), time is running out for this bear market rally – the flow of economic (bad) news is coming as most of the advanced indicators are already red since a few months. Everyone wants this market to go to 1150 and it might very well reverse before. Stay tuned – it is cheap to hedge by buying put so you have been warned.

And just for those who do not believe in the power of the golden number, see this:

Superimposed is the daily S&P500 as of Friday, July 30th, with the fresco in the St Louis de la Guillotière church, Lyon, France. Hat tip and all of my best wishes to my friend Emmanuel who get married there last week-end.
With God forming the April top of the market and scaling the left shoulder to match His left buddy, the market will surely miss the second shoulder objective (1150 S&P), as marked by the head of His right mate (may someone with better religious knowledge as myself please add the name of those two personages into the comments).

On triangles, carry trade, HAL 9000 and the flock of black swans

2010-05-26T23:35:00.000+02:00

As of today, markets have seen an almost continuous fall from the 1220 level on the S&P 500 – just below the 61.8% retracement target. From a technical stand point, the main market action has been a series of triangles – patterns showing confidence in the continuation of the decline. The present situation followed the numerous divergences we noted on April, in the last days of the bear market rally (divergence between technical indicators, bonds and stocks, foreign exchange, carry trade pairs…) – that was the main trigger of my previous sell call.
The recent rout in equities has been equally matched by a huge liquidation of carry trade positions (note the crash of all of the JPY crosses and the fall of the Australian dollar) – this making this correction different from the previous ones. Once again, seeing the big guys – especially the late comers to the carry musical chairs - being massively forced to liquidate their position with huge losses (“Carry traders being carted out of the floors in body bags”, as stated on Zero Hedge) – is not a sign of a healthy market.
Time should come when regulators (be them central bankers or anyone else) prevent the carry trade has being the only possible source of profit for financial and non-financial institutions – otherwise the instability of the system will continue forever until a devastating crash takes everything with it.
Exacerbating the recent correction has been the so called May 6th flash crash – or fat finger error. This most stupid explanation for a 1,000 pt-intraday loss on the Dow – as spread by the official financial press – has been a desperate attempt to hide to the investing community how an overbought, over valuated and over manipulated market can turn into a bottomless pit when suddenly the apparent liquidity is withdrawn when, following a loss just slightly larger than previously, the HAL 9000 supercomputer controlling the market decide to remove a bid – and this time is followed by all others, turning an “orderly decline” into a bidless panic.
A lot will see this event as a black swan – adding to the list of all the other we witnessed those recent months – Dubai bankruptcy, Greece debt rout and not to mention the one flying at 20,000 ft – the Icelandic ash cloud, capable by itself of bankrupting most of the European airlines.
This was one of my original thinking for 2010 – that we will witness a lot of black swans – of course being black only for those expecting a continuous rise of the markets up to the sky at that time.
As regards the Eurozone black swan, some questions have been raised on the impact of the ECB starting buying government debt, and its longer term impact. As usual this kind of intervention is counterproductive as it encourages a continuation in unproductive misallocation of capital – why not forcing investors and banks to recognize a loss and start with a cleaner system – of course European banks would require a huge raise of capital? However, I do not expect a German-ruled ECB to switch to instant monetization of the Eurozone deficit. I see the last weeks move as an attempt to trigger a short squeeze in Mediterranean Europe bond markets – attempt that will ultimately prove to be a failure. If the EUR 500+ billion bailout attempt were for real, the market would have experienced a sell-off of the Bund (why holding German bonds yielding sub-3% while holding the same maturity Greek bond with explicit German guarantee would yield more than 6%?). On the contrary Bund experienced a huge flight-to-safety rally.
The coming EUR/USD rally will be another black swan event – forcing all of the wrong-way bets to cover simultaneously – maybe triggered when the market will ultimately realize that a default in Eurozone is not only possible, but the preferred option. And do not forget the area the most in need of monetization is not Eurozone with its overall high saving rates, but bankrupt America at the mercy of its foreign creditors.
To end with some trading recommendations, short equity indices (and specifically its most leveraged components) is still my advise, adding in rebounds like the post-bailout one, while some covering should be initiated when the markets become oversold (by selling index puts for example). I recently tried to catch the EUR/USD falling knife by buying some call options with no success – forex market is currently very difficult to trade rationally.
In the coming weeks / months (maybe during summer), if a significant sell-off were to occurs in equity (taking the S&P to the mid-800), I may try to turn my short position into a more convex option combination - making a lot if the market correction continues while limiting the loss in case of a rally – one should happen sometime as per Eliott wave theory. More on that later.

Market update

2010-05-04T22:46:00.001+02:00

Some brief update as of today as the market is selling off on realization that Greece will default on its debt (which it will), and that the EU/IMF bailout envelope is too small to prevent contagion to other Mediterranean states.

Some broader macroeconomics points:
- there is currently a bubble in US assets (stocks, treasuries bonds, junk bonds) fuelled by carry trade and Europe sovereign speculation
- there is a real estate bubble in Australia (it is at the equivalent stage of the US in 2006, that means at the top of the frenzy and at the top of prices as well), and one in UK (+10% on real estate price in one year)
- the peak in the US economic recovery has been reached (notice the surge in inventory) and will be soon visible in the mainstream indicators
- all the intends to restarts credits have been unsuccessful, due to lack of demand and economic agents preferring to play the carry trade with cheap liquidity rather than lending

In currencies, USD, GBP and AUD are overvalued vs. EUR and certainly JPY as well. EUR/AUD is a buy, EUR/USD will be when sentiment on EUR becomes overly bearish (we are getting close).
In stocks, prices evolutions have been characterized by rising tops but a lot of divergences appeared recently, as another clue that the top has probably been met (although a final rally can take the S&P 500 back to it final objective of 1220-1230, sometime before July I think):
- stocks making new highs but volatility not making new lows
- US indices making new highs but not European ones

My position is thus still bearish on stocks. If sentiment were to become extremely bearish and the market oversold, I would try to cover some of my shorts by buying calls or maybe selling puts if volatility breaks higher. I still believe European automotive sector and Apple are good short candidates. GBP is a sell, I think the bond vigilantes will have a stop in London after their southern Europe tour, coinciding with the UK election.

Finally, I restate that Eurozone break-up anticipations are exaggerated. The outcome of the sovereign crisis will be more solidarity in the Eurozone sometime down the road, with the austerity imposed in other countries earlier than otherwise, and not only in the so called “Club Med” ones. This is for me the only possible way (shared austerity), and will have long term beneficial impacts on Europe and the EUR (don’t expect the same path in US – which is why in the longer term the EUR/USD exchange rate can only go up – and remember Europe has positive saving rate, and can thus finance its deficits itself on aggregate).

Stay tuned…

Sell!

2010-04-13T22:49:00.004+02:00

Here we are. Maybe once again I will be (far) too early in the call. However recent market events indicate the top is here, or near. From a technical standpoint, overbought conditions close to the 61.8% retracement (circa 1230 on the S&P 500) indicate the ceiling is close, while there is no floor under the current valuation. My fair value estimate of around 800 for the index is still valid, and the current earning season is certainly not going to make me wrong (I expect earnings to top this quarter or maybe next, and not continue to the further 30%+ rise every pundit is forecasting without any credible justification) - so the market is overvalued by close to 50%.
Of course, as usual the market prices are likely to undershoot to the downside, making the 500 target on the S&P a not-so-remote possibility (in 2011 or 2012 I think).
From a timing perspective, we are at the end of the bubble, as we witness a lot of agents locking-up current interest rate by selling as much 5Y junk bonds as possible, while every private equity fund is rushing to IPO what it can. With the top in US GDP growth last quarter (as seen by a lot of advanced indicator recently turning lower) and going negative in Q3 or Q4, and considering the market anticipates the events by 3-6 month tells me the window is here.
What tells me we are getting so close is the through in volatility, showing nobody expecting any significant correction. For this reason I started accumulating put option on the S&P on top of my short position in the European indices.
I closed most of my remaining long stocks position and kept only low price-to-book and high-dividend positions and closed my short position on US 30Y treasury (making pocket money on it). As usual I expect the dollar to rise together along the equity correction.
The sectors / companies to shorts, in addition to overall stock indices, are as usual REIT, European automotive (with austerity coming in Europe and the need to end subsidizing this industry, expect auto sales to crater), and Apple (with the fall on the Euro, a back-of-an-enveloppe calculation gives a 15% drop in their profit on Q1, which is certainly not what the market expects). Oil is a good mid-term short while dangerous due to the current geopolitical situation and seasonality (better wait for the first hurricanes to enter the Gulf of Mexico or the first bombs to fall on Iran ground)
Thats all for today, more as this unfolds...

Coming soon in a street near you: public worker unions vs. bond vigilantes

2010-02-14T19:08:00.003+01:00

Recent events in southern Europe lead to anticipate a coming period of austerity in those countries. Anglo-Saxon commentators already emphasize the rise in sovereign risk as the end of the Eurozone (a grossly exaggerated assertion, as Greece and Portugal are a tiny part of Eurozone GDP) – those comments are more to hide the decreasing solvency of their own states – UK, California and New-York state. California and New-York state, that are already technically bankrupt with no chance of return, contribute by a much bigger share of the GDP of the US as southern Europe accounts for the Eurozone. Moreover, Europe has enough internal savings to finance those deficits, which is not the case of US and UK. The recent fall in the Euro (even against the GDP) has been the consequence of speculators (rumours of George Soros being in) rushing to sell euros, together with margin calls triggered on carry trade positions involving selling the dollar.

Back to the original discussion, as for whatever state we consider, austerity will come, and probably earlier than the governments are ready to deal with it. Governments will have no choice, under the pressure of bond vigilantes, to reduce spendings and raise taxes; otherwise the raise in interest rates they bear on their debt will mean “Game Over”.

Rising taxes will yield limited effects, as the recession already significantly hampered the ability of the shrinking middle class to pay income taxes. Marginal gains will come from raising upper level taxes, especially in the US, another being to rise corporate tax - big companies in developed world pay a ridiculous part of their profit in taxes (impacting once again the appeal for stocks for the long term).

For Europe in particular, the public sector contribution to GDP will have to shrink. A few options are available:

- reduce pension and medicare promises

- force gains of productivity in administrations and public services (that means improve efficiency and remove “unproductive” workers – and there are a lot!)

- reduce public worker salaries – hopefully on a fair basis (a lot of high public salaries have to be reduced, a lot of low salaries can’t)

Any of these options will be met by anger by public worker unions, who invariably and selfishly defend their own position at the expense of the society. For sure, confrontation with the government will lead to clashes, and any government will be shy to attack their political power, unless forced by the bond vigilantes.

The shrinking of the public sector is just one side of the hard decisions the government will have to take before the end of the current cycle. More generally, a realisation that a lot of promises cannot be fulfilled will have to be shared with the mass, especially that neither the current standard of living cannot be maintained forever, nor all of the retirement promises. Only when the mass are fully educated can the government take the harsh decisions without voters’ retaliation – a wishful thinking, I have to admit.

My hope is that this adjustment process will go in equity, and that the money will be taken not only where it is, but where it does not deserve to be. A significant part of the effort should be taken by upper level public workers and generally to all of the “protected” workers – whose wage legitimacy is from an old age – I mean salaried workforce of big companies, especially former state companies in Europe, and especially the least productive, or those of company or professions with significant monopoly power. The growth of the past two decades has led to significant incomes and social benefits discrepancies between the sectors and company size and hopefully the coming unavoidable deflation will correct some. Especially, I hope the ability to start new business and innovate with the support of the state will be promoted – the only way to compensate for the loss of the activity linked to the old way of living, and its associated jobs, and to go back to prosperity.

The path followed recently to react the financial crisis has been to protect the bond holders of the financial institution (instead of bankrupt them and reduce the claims of their bond holders) – that means protecting big pension funds and hedge funds – in order to protect the wealthiest part of the population, but not the most productive. This current situation, especially leading to 25%+ unemployment amid the youngest class is not politically sustainable – the pain needs to be better shared.

To go back to the recent events in Greece, a lot of speculation has been spread about who’s next on the list of potential default. I read with interest the interview with Richard Koo of Nomura who compares US with Japan of the nineties, claiming that fiscal deficit, especially those induced by stimulus spending are sustainable as long as they are offset by a rise in individual savings. I am not confident in this theory as, looking for the latest data, the rise of US personal savings (since the beginning of the recession) is around $400bn a year, which offset the reduction in the current account deficit (by the same $400bn a year amount) – that means the ability of foreigner to continue buying treasuries bonds in exchange for goods sold to the US. I agree that this personal saving rate will continue to climb and probably even double, yet the funding gap and the accumulated in- and off-balance sheet liabilities are too high.

The 2010 Baseline Scenario

2010-01-03T23:22:00.002+01:00

As it is de saison, here is my outlook for 2010. Before addressing today’s topic, I will begin with the consensus.
Consensus is for a continuous expansion through 2010 and 2011, US consumers weakness being overtaken by strength in emerging market and their ascending middle class. This will continue to drive commodity prices up, while inflation will remain low, profit of companies will soar as their productivity will continue to rise, their debt is in the process of being refinanced at lower rates and extended maturities. According to these rosy expectations, the Fed will first remove the no-longer-needed excess liquidities and then tighten short term interest rates in the middle of the year as growth picks up.
Under this scenario, stocks are cheap and will continue to climb at least 10% (and after ? No one seems to know), corporate bonds, especially bank senior and subordinated debt are damn cheap as no default will ever occur.
The mainstream economists and sell-side analysts see the current economic situation as stable, business as usual. As usual, they extrapolate the recovery tendency we have experienced these past two quarters and assume the same growth rates of corporate earnings, while ignoring any downside risk. Remember that extrapolating curves led to the current crash (only a fool could assume that the risks spread of subprime would continue down to zero).

There are three major risk to this scenario which make it very unlikely :

if growth continues at this pace in emerging countries, with already creeping inflation (Chinese inflation is certainly closer to 5% than the near-zero officially advertised), central banks will have no choice but to rise interest rates, crashing the already-overvalued stock and real-estate markets, leading to an economic slow-down
as commodity inflation will be the first to pick-up (it already has), producer price rise will lead consumer price rise (the trend had been inverted in 2009, explaining part of the recovery in corporate profit margins), thus squeezing profits
together with the perception of inflation risk, the low yields of treasuries will push investors to ask more for buying them in a recovery environment, increasing difficulties to fund the ballooning public debt

My outlook assumes the following points :

consumer spending flat in developed countries, especially those with a growing need to increase savings
flat GDP in US, Europe, Japan, increasing (not decreasing) unemployment there. Some GDP gains due to inventory rise, however a continued deterioration in residential and non-residential investment (no sign in pick-up by year-end 2009)
continuous losses for banking system (especially US) due to increased loans delinquency (residential as a consequence of the rising unemployment, commercial as a consequence of lower shop and office occupancy – a result of lower consumer demand and no pickup in overall activity)
no voluntary fed fund rate increase until end 2011, as it would crash a weak banking sector and increase adjustable rate mortgage delinquency (no peak in ARM reset until end 2011).

To this tendency the following factor are likely to negatively affect the economic outcome :

no increase in US current account deficit (the rise in imports witnessed in Q2-Q3 2009 is not sustainable and has been driven by stimulus spending, while exports should prove more resilient)
upward pressure on treasuries yield, due to the conjugated effects of lower foreign buying (remember the decrease in US account deficit means less dollar for foreigners to buy treasuries), an increase in perceived sovereign risks (insolvency of counties, states and then the federal government will finally be evident to the investing community)
flat corporate earnings as easy productivity gains no longer exist, and sales do not pick-up

Below are listed the likely impact on the various asset class :

Equity and corporate bonds

The year-end of 2009 has witnessed a lot of signs of a top or near-top in the most risky assets (stocks and junk bonds) :

all commentators are bullish (a contrarian indicator that the trend will soon reverse – remember 2007)
the market is overbought by any measure, and the volatility is at record low
leveraged companies, private equity funds and financials are rushing to sell new debt or shares (think of Citi and BoA rising capital to reimburse TARP, or private equity funds loading their company balance sheets with new junk debt in order to pay themselves huge dividends) – a sign that the current rally has been engineered in order for the big guys to get out of the market and selling their trash to credulous investors, knowing that this liquidity bubble will soon have to come to an end – once again remember 2007 and its M&A boom
a record flow of insider selling (company insider being convinced the company they are working for are not worth their current market price on a fundamental basis)

Thus I do not assert the market is ready for a crash or a major sell-off. From a technical stand point it may even continue to rally (maybe up to 1150 – 1220 on the S&P) until sometime around the end of Q1, as Q4 corporate earnings might appear relatively strong and December employment good.
However more risks are on the downside. Speculators may wait until new highs, or wait for the downtrend to be firmly established (when major indices close below their early November lows) to open large short positions.
I have no price target on major indices, although ultimately I think they will end lower than the March 2009 bottom under long term deflationary pressures, yet this might happen only in 2011. Stocks are currently overvalued by 30 – 40% assuming a more realistic earnings growth than the consensus and a P/E close to the historical average of 15, leading to a target in the low 800 on the S&P (could be a target for this year). In a more depressed environment which I think is likely, P/E in the region of 12 could be expected, leading to a target of 500.
Another possibility for 2010 is a market going nowhere, which means staying in a 900 – 1100 range on the S&P. As a consequence, trading on a time-sensitive basis (like buying put options) could be very frustrating.

Emerging markets

Emerging markets are grossly over-evaluated and as it will be clear the internal demand will not offset the external demand before a long period of time, the bubble will bust, certainly sometime around the middle of the year.

Energy & Commodities

Oil price seems once again driven more by geopolitics than fundamentals. A lot of market operators are pricing in an Israel air strike on Iran targets. On a fundamental stand point, inventory are high, higher than reported due to the unaccounted for floating storage, demand is low in developed countries, and the perceived rise in emerging market demand has been driven more by speculation-induced storage.
From a supply-and-demand basis, markets are well supplied, OPEC has probably around 2 million barrel a day of spare capacity (although less than the 4 – 5 mb/d considered by the consensus). Even a complete shut-off of Iranian supply is manageable. The none-OPEC supply continues to be flat despite high depletion rate; however a lot of new supply has been added during the high of the market in 2006-2008. The curtailment of investment in 2009 will be felt later, likely from 2011.
So I do not think time has come to play the return of the secular rise of oil prices, I would rather wait for sometime around mid year, where I hope the geopolitical premium will disappear and more information will be available on a potential double-dip global recession.
Being short the oil market from now seems very hazardous due to the Iranian wildcard.

As regards other commodities, a lot of building-activity-related metals are likely to crash with the emerging market construction bust to come. Agricultural might be the place to be, although their outcome is strongly linked to weather…

Treasuries

As discussed earlier and in previous posts, I think all the conditions are being met for a long-dated treasury bonds crash. Supply-and-demand balance is likely to be critical in 2010, while the long-term outlook is very bleak especially in the US whatever the inflation or deflation outcome.
US treasuries might rebound in case of a major equity sell-off, which would be the ideal point to add to short positions.

Currencies

I do not manage to draw a clear picture on the US dollar in the mid term. Although long-term it has to go down (as it is increasingly being backed by the Mortgage Backed Securities the Fed bought from the financial institutions, which ultimately should yield losses in the 20 – 30% range), another powerful argument mid-term in favour of the USD is the decrease of the US current account deficit, a trend that should continue when the recovery in the US will fizzle (driving imports down) – meaning USD will go up mid term.
As regards the yen, the current downtrend is linked to the return of the EURJPY and USDJPY carry trade (now that the EURUSD carry has been killed by the rise in the dollar). So the yen will for sure rise as soon as an equity correction will begin. However, long term I do not see a lot of other reason to be bullish on the JPY.
The Yuan is certainly a big chunk to the currency puzzle. The consensus is for a re-evaluation sometime between Q1 (for the most optimists) and Q2. I do not believe in it. When it will appear evident US consumer demand will not pick-up, and with over-investment everywhere in China, I do not see what will warrant a currency rise, devaluation risks having even been pointed out by some contrarian analysts.

Gold

I will detail what I think of gold in another post. I am not a believer of the disappearance of fiat money any time in the future, and as the gold rally has became a crowded trade, and with the big guys being short gold, I do not believe in the $2000+ an ounce target and would expect more of a price range in 2010, like 900 – 1200.

Real estate

Real estate outlook has to be seen on a 20-30 year basis to consider an investment. Be it commercial or residential, in Europe or the US, I still think the market has further to fall to adjust to demography, future incomes and economic activity, and perception that no upside in price exists. Currently the residential market is heavily distorted by government intervention and low interest rate, why inventory and shadow inventory of houses are huge in post-bubble markets, with no chance of a lasting rebound (which would be used by bank to unload their vast properties holdings).
Playing a crash in US commercial real estate is possible by shorting the Real Estate Investment Trusts, which show bad fundamentals (although the bankruptcy risk is rather low for most of them) and are probably over-valued by 30-40% (even Goldman Sachs was saying that). Buying the inverted ETF labelled SRS is a possibility. It offers an inverted 2x leverage.

The unintended consequences of productivity rise

2009-12-27T22:22:00.000+01:00

Some weeks ago, I had a conversation with a workmate who explained me how the next generation of automated production lines could work with minimal human interaction by staying maintenance-free almost twice as the current generation. We also noticed that even in a very different sector as education, a lot of efficiency and cost reduction can be achieved by switching to e-learning.
How economy and societies adapt to long-term gains in productivity is worth a discussion here.
From the invention of automated machine woven to the steam engine, then the use of electricity as a way to optimize plants layout (no longer a need to have machines on several floors centred around the power shafts connected to the steam engine), the invention of moving assembly lines, pioneered by the automotive industry, then the introduction of automated machining and assembly helped by development in computers, to finally the introduction of modern Enterprise Resources Planning systems greatly reducing the need of white collars (accountants, sales administrators, …), the last two centuries have witnessed a lot of productivity revolution.
The way we dealt with their consequence varies a lot depending on countries and political systems – consequence in terms of shrinking manufacturing and agricultural employment – made worse by offshoring a significant part of manufacturing.
On one side, Anglo-Saxon systems have turned to overinvestment in residential and commercial real estate, an oversized banking sector and un-productive services, along with other-consumption by households. Another significant contributor is the huge military spending. All of these made possible by no-limit borrowing.
On the other side, continental Europe compensated the less available jobs by assigning a lot of resources toward healthcare, well-being through reduction of labour time, and increased incentive to spend on leisure.
The former way leads to inflation (high labour occupation) that only recession can bring back into control, the latter put pressure on competitiveness as productivity gains for corporations are compensated by higher unit labour cost.
Another track that has been followed on both side of the Atlantic is to increase the bureaucratic burden as a way to create high-paid, monopolistic employment – think of lawyers, accountants, tax managers, as well as an increase in the number of local administrative subdivisions, in order to increase the number of public employment, especially at management level.
As all of these measures led to an unsustainable amount of public debt, at a given time governments will have no choice but to switch to a “lean” way of work. The government as the employer of last resort will be something of the past. How will massive unemployment be dealt with ?
At the global scale, a slowing factor of the necessary adjustment has been to offshore manufacturing and services to lower cost economy, basically less productive, to delay the day of reckoning (by reducing the overall productivity of the world economy)..

There are basically two options at the developed countries level: the first is to rise competitiveness through reduction of unit labour cost (through monetary devaluation and massive reduction of living standard or a return to outright protectionism – or a mix of the three), in order to take manufacturing jobs back to developed countries – a rather unlikely outcome short term, as this would crash emerging countries and rise political tensions, yet it could be the dominant theme of the longer term (see my previous post on the US dollar).
The other possibility is that under the weight of rising energy prices, the tendency of the rise in productivity will revert. Under this hypothesis, manufacturing will have to come home and food be grown locally, in smaller structure thus reducing the economy of scale that globalisation brought in recent years. Emerging economy would be forced to become less dependant on export to survive, forcing the development of low-energy, interior demand – not an easy target.
Both outcomes are not very favourable to the continuous gain in profit margins of multinational companies, be they from the developed or emerging world – one extra reason why I have negative on stocks on the long term.

Inflation or Deflation ?

2009-12-23T13:51:00.001+01:00

Every economic blog claiming any significance must deal with the billion-dollar question for the long term investor : will inflation or deflation be the dominant theme of the coming years ?

There are three main reasons why inflation is not the probable outcome, one of them being broadly called in the mainstream media, the second less, and the third not at all.
First, the world experiences a lot of excess capacity in manufacturing and services, and in addition with employment still rising around the world, don’t expect upward pressure on wages and prices in this environment. Moreover, contrary to what should happen in an undistorted market economy, excess capacities are increasing, not decreasing, as China continues to invest in factories. Add to that shrinking credit and money velocity despite all of the governmental efforts for bank to lend again, and the odds of uncontrolled prices rise are low – al least for the short term.
The second reason one will hardly read in the press is the low duration of government debt. In order to reduce their increasing debt burden, and with the deflationist pressure of the previous two decades, governments have been doing their own form of carry trade, by borrowing short-term to fund long-term liabilities. As a consequence, the duration of government debt (ie the average maturity debt for US treasuries) is between 3 and 4 years and shrinking due to the very-short term borrowing to fund the various bailouts. With the various auctions of long term treasuries having been a failure, absent an outright equity correction and flight-to-safety, do not expect the government to even try to increase its maturity by selling long-dated treasuries.
For this reason, the government has no interest in creating inflation to wipe-out the Net Present Value of its debt and spoil its bondholders, as it will have to constantly roll its debt to higher interest rates.
Then the last reason you will not read anywhere – the demographic one. With ageing people in all of the developed world, the bigger part of the population – and more precisely, of the electorate – will lose the most with inflation. As usual, the government – and thus the ruling party – will be blamed for it. The inflation in the 70’s had not the same political consequences as the majority of the population was in its twenties and had no wealth to protect.

So the most probable outcome is deflation – a continuous fall in all assets price where cash is king. The deleveraging process is underway – first households, then corporations – which has barely started, financials and last governments – no other issue is possible long term but to rise taxes and cut expenditures.

So what are the investment impact ? Whatever the outcome, I believe treasury bonds, especially US, are a big sell. If inflation picks up, the rise in interest rate will decimate the Net Present Value of holding long term treasuries bonds. If deflation leads, the decrease of government revenue due to the decrease in nominal GDP and the increase in Net Present Value of the accumulated debt with expenses decreasing at a slower pace (how could health care expenses decrease with an ageing population?) will push governments closer to default, increasing risk and competition to attract investments, leading to higher long term interest rates.

Again, the issue is timing. Currently, stock markets are pricing a return to inflation, inflation they expect company can pass to their customer faster than the rise of their costs (raw materials, energy & utilities, wages, services,…). On the other side, bond markets assume deflation, and yield staying low for years, while neglecting the sovereign risk – which came back with a vengeance these recent weeks with Dubai and Greece.
Reality is that markets are grossly distorted by the free liquidity and short term money in the system. The “same tide lifting all boats” could morph into the “same avalanche sweeping all houses”. When it will be clear that the bubbly peak in corporate profits (due to a combination of leverage, worldwide sales growth, housing bubble and low dollar) will not return, the 30+ percent of overvaluation of stocks will fade, and when it will be evident that future growth will be insufficient to cover government obligations, prices of bonds will follow. We will be ready for new lows on the markets.

One other possible outcome worth discussion is compartflation : a mix of inflation on raw materials and energy sector – consequence of a decline in confidence in dollar and continuing pressure on supply (assuming steady growth in emerging countries), together with an outright deflation on wages, real estate and stocks (due to excess capacities and the squeeze between rising cost and shrinking prices) – that mean inflation for the poor and deflation for the rich. This is however not my baseline scenario as I expect emerging market to crash sooner than most commentators do.

Disclosure: short long-term US treasuries

Only in China

2009-12-06T09:51:00.005+01:00

I am starting this post 30,000 ft above the Middle Empire aboard a 777, as comfortable as you could be seating in a coach seat, returning home after a short business trip to Shanghai, which has been a great opportunity to discover - although in a very small extend - what bullish commentator continue to call the “Chinese Miracle”. From the fantastic landscape seen from a cloudless sky arriving over the inner Mongolian steppes and deserts to the countless terrace-shaped rice-growing fields – the results of an incredible amount of labour across the past centuries, the crossing of the thousands-mile-long Great Wall, the grace and beauty of ancient Chinese architectures and artworks are worth the 20,000 kilometres travelled and the sleepless, jetlag-induced hours.
Yet as Paris is not France and New-York is not United States, Shanghai is certainly not China. The economic showroom of China, although looking increasingly like our over-developed world is not really what will make change the mind of a China-bear like me.
The buoyant, rumbling city full of honking taxis, wrong-way-ridding bikes and scooters contrast with sky-high skyscrapers separated by in-the-air-floating highways à la Gran Turismo as do contrast foreigner-occupied residential areas with traditional, low income, street shops, restaurants and markets with their on-the-ground lying piece of meats, or migrant workers living in temporary barracks few blocks from the luxury cars or jewels shops.
Lessons learns from the visit are drawn from those contrasts : how can a country thrive with such visible inequities, and how can such world-class infrastructure (take the Maglev train from the airport for a smooth ride at 300+ kph) and moderns skyscrapers hide a city of 20 million inhabitants that can not provide drinkable water to them.
Secondly, it looks like the basic lessons of our overdeveloped world have not been understood: the concentration of economic activity in a small area lead to congestion and thus to un-productive time lost in transit (the result of people being pulled away from their workplace by the housing bubble), and bottlenecks in the supply chain, leading to inflation. A lot of parallels emerge with what were US in the sixties and Europe in the early seventies – a fast growing economy with anarchic infrastructure and construction planning, which led to the late seventies slump – only this time, China will not benefit from cheap energy as the West did during their golden era.
Another striking point is how dependant the economy is on Foreign Direct Investments and the direct presence of foreign expatriates as source of cash and labour. Not sure the country is ready to withstand a sudden stop of FDI, as will Dubai certainly endure following their recent debt rout.
Then, another concern is the dependence on low labour cost – be sure that for a long time, government will make anything under its might to keep a competitive advantage, especially over its neighbours, with all what is implied for the RMB exchange rate.
Strictly from a business stand point, three areas would not make me confident, at least from an investment stand-point: state-owned enterprises acting like shadow banks, receiving loans from state-owned banks and investing their surplus in stocks and real-estate, inflating the mother of all bubbles. Then, the absence of any notion of Return Over Investment in most of their projects (why continue to invest now in industry with so much overcapacity around the world, or continue to build office skyscraper where a lot are empty – a walker along the Bund at dusk will witness a lot of dark floors in the flagship “bottle-opener” skyscraper). Finally, the Chinese society itself and its pyramidal organisation is not the basis for a high productivity, of quality and innovative work – our transverse, product-oriented and people-positive management is far from being the standard, although things are certainly changing fast.
To conclude, I doubt China will be the driver of the world economy everyone is claiming, and that its growth will continue at its current unbridled pace forever without hitting the wall. I am not confident an export-oriented, bubble and inflation-prone with such unbalances, in a deflating environment with overcapacity can continue its way unabated. Although from a long term perspective, China is a place to be (stable population, improving infrastructure, central and stable government), the ride will be bumpy as a consequence of the choices made today by the administration, which has no other choice but to provide jobs for everyone at any social, human and financial cost – I witnessed workers sweeping the road in the middle of a crowded roundabout… only in China.

Other photos here.

The October, 19th 2009 stock market crash

2009-09-19T21:07:00.005+02:00

Giving a date and a stock market price target at a given date is probably as fuzzy as forecasting weather beyond 10 days from now. Anyway I will stick to this bet – at least for posterity, although I do not know if it will be a rainy or a sunny day -this could have an impact anyway – remember 1987 when the flooding in UK and the inability of trader to go to work the Friday before to close their positions made them nervous all the week-end long. Even UBS stock strategist Art Cashin that you can regularly read / watch on CNBC calls recently that the coming equinox could have an impact on stocks.

So why the 19^th of October ? It is a Monday (remember Monday is a crash day), it follows the October option expiry Friday (the 3^rd of the month), it is a period where macroeconomic indicator should have turned red again (although I think the coming correction will have nothing to do with any turn in the indicators) – especially September unemployment, and the Q3 earnings season will be at full speed, adding to volatility.

To go back to earnings, look at the latest S&P500 earnings estimate from S&P. Their updated spreadsheet show flat earnings going forward through 2010, and an at-par growth of operating earnings – at a rate of growth more in line with the past 20 years, not with the past bubble era.

That means, from a valuation stand point, and looking at comparisons on the pre-bubble years, let say 1995 (before the start of the dotcom bubble when P/E bottomed), investors were asking for a P/E of 15 for a rate of growth close to what S&P is forecasting (in terms of operating earnings). Assuming their $53 of operating EPS forecast for 2010, one get an 800 target for a “fair value” S&P500. This is notwithstanding any further downside risk (to growth, bank writedowns and so on).

With the risk of earnings deceptions and a return to extreme risk aversion (i.e. investors demanding a P/E of 8 to 12 to own stocks), the undershoot potential for the index is much lower – probably below by previous 660 call. A look at the graph below drawn from the S&P spreadsheet illustrates the rate of growth and historical P/E. (click to enlarge)

So here we are. The market is overvalued, overbought and trade at low volumes, the latest fallacy of the sell-side pundits being the retail-investors ready to jump in, with a lot of cash in the sidelines.

We are in a liquidity-driven market (zero interest rate and the EUR/USD carry trade). As long as the party continues, we can expect even a parabolic rise. However, I do not believe a lot in this. At a given moment, someone has to say it is enough, unless the situation will become unstable. And the best solution for anyone (treasury or Fed if you wish) to regain control is to stop this mania and to crash the market, in order to drive a flow again to safe haven treasuries and the dollar, all of that without the need to rise the interest rate (which unless forced by a massive dollar crash, will be postponed later in 2011).

The next down move of the market, as it will come, will probably not be the big one. Once again, remember 1987, the crash started after a first correction and a new rise. The big guys need this rise to exit.

To give a target to the upside would be 1120 on the S&P, which is about the 50% retracement from the 2007 high to the March 2009 low, as well as a long term moving average, by the time when the short term indicators will be significantly overbought if a parabolic rise were to start following the exit of the ascending wedge that started in March. Yet a good friend of me, who already forecasted a lot of market moves rather accurately, told me the party could continue, the technical analysis is of no great help under those irrational market conditions, and that he is watching any new negative factor, should it come from interest rate or currencies, to go short.

From a trading stand point I started trimming down my long EUR/USD position gradually to play a rebound of the dollar, and replacing some of my short index positions by put options to slow down the bleeding of capital that could take me to the ruin if this parabolic move were to continue and not stop as planned.

The fate of the US dollar

2009-08-01T21:38:00.002+02:00

“For the sake of the argument, let's consider a low-cost country, for example United States.”

The last time I argued this in a business meeting, it yielded laughs first, then some kind of consideration. At least from a European perspective, the EUR/USD exchange rate confirms this statement. A country whose unit labor cost decreased 30 – 40% vs. the EU in the mater of 7-8 years could be worth ranked as a low-cost one. Yet this is probably just an overview of the (near) future.

Considering without doubt that the three decade-old model of “all service – no manufacturing” economy is now broken, with the coming rise of transportation cost, and with persisting high unemployment at home, the next background tendency must be the re-industrialization of United States.

For that to happen, the dollar vs. major currencies including the yuan must go down. The US administration will bless any fall of the dollar, despite its official support of a strong dollar (don't laugh !). It is pure folly to hope for a continued long-term support of the dollar by exporter countries as their trade surplus is falling due to lower demand from the developed world. Emerging country are already in the process of reducing their holding maturity (selling long term treasuries and agencies / buying only short-maturity treasuries), in order not to suffer the double whammy of losing the value of the bond and the value of the currency.

This environment of weak government and international support for the dollar, increasing commodity prices in the mid term should be a fertile environment for carry trade and should see a lot of speculators selling the dollar to invest in the commodity complex, or in currencies abroad, in a self-sustained motion.

Of course, this fall of the dollar will spark inflation, probably a lot. In recent years, CPI has been very well correlated with the US dollar index as United States imports most of the goods it consumes.

Before this unfolds, expect the bond vigilantes to stay relatively tamed, as any pressure on price expected to remain low due to excess capacity, no labor cost pressure and ample oil inventories preventing any significant surge in prices. However, any start of a new speculative mania (sparked by ample liquidity, low inflation expectation, low short term interest rate) could well accelerate the flow out of the dollar, while a Chinese stock market crash (more and more likely as stated by economist Andy Xie) could temporarily provide some support.

The only halt to this coming dollar fall / price rise spiral is perception the fed is going to raise short rates. Knowing that a lot of adjustable rate mortgages are going to reset well into 2011 (especially those issued at the peak of the housing bubble), raising interest rates before 2011 will be a slaughter for a lot of households and the slow-heeling banking system. Moreover, with the mountain of short-term treasuries recently issued to mature around this date, any rise of interest rate will cause pain to the government.

The way the dollar falls, from a progressive, controlled fall to a disorderly crash is certainly the key to the final outcome. The longer term equilibrium, anyway, should be a very low dollar to keep an unfair labor cost advantage especially vs. Europe, higher short and long term interest rates to keep money flowing into the US and a need for a return to fiscal discipline, that means in particular a significant reduction of defense budget, low social security and health care benefits, and a living standard reduction of probably between 30 and 50% to re-balance. Not the outcome everyone is expecting, especially those assuming a quick return to the glorious old days, especially in terms of corporate earnings. A lot of pain along the road and probably a second recession in 2010 – 2011.

Although some US firms could thrive in this environment, a lot are probably going to be squeezed, with overcapacity slow to be removed, a slack in demand locally (limited wage growth and continued household deleveraging), meaning limited pricing power on one side and a rise in raw materials price on the other side. A lot of time will be needed to adapt corporate America to a new environment.

Disclosure : long EUR/USD

The birth of a new bubble market

2009-07-19T21:13:00.000+02:00

The least we can say is that it has not been a great week for short sellers like me. The great bounce of 7% as been enough to turn all of the mainstream media commentators from bears to bulls. From a contrarian standpoint it is thus perfect time to sell, as well as from a technical standpoint, with mostly overbought short term indicators, key resistance in the 940/950 for the S&P and a cap by the 200 days Exponential Moving Average. Add to that the reason given for Thursday advance, as Mr Roubini turning bullish (I really laughed as I read that on Bloomberg), and you are it. No reason for a profound change of the trend.

From an intermediate term, do not expect any improvement in economic conditions worldwide: growing unemployment, a new wave of foreclosure this Fall due to interest rate resets, and for the beginning of next year, a wave of refinancing of underwater commercial real estates deals (as the CRE mania peaked in 2005 and most of the financing was on a 5-year basis).
As a consequence, do not expect improvement from the banking sector (leaving aside the big ones and their unconditional, unproductive and probably unlawful support by the taxpayer, and their quasi monopoly in trading of some products which guarantee them a lot of profit short term – but this could be the subject of a lot of other posts).

From a valuation perspective, assuming that long term earnings of S&P500 companies are only going to recover about 70% of their 2007 peaks (due to lower leverage, long term excess global production capacities, and the cost of the accumulated debt), this could let us expect an “all clear” S&P earnings of around 55. Then, assuming a long-term, unspeculative P/E of 12, and you are to, guess what, 660 on the S&P (just the March ’09 low) so with an S&P at 940 you are far from being undervalued and thus the market already assumes a return to the 2007 bubbly, overleveraged peak of earnings. As of today the S&P estimates for the next 4 quarters (2Q ‘09 to 1Q ’10) are 32 and, at 940 this gives you a P/E just short of 30. Not really undervalued either.

Now from a long term perspective, I see no reason for unbridled optimism. The era of high savings to invest, lowering worldwide labor cost, global imbalance forcing emerging countries to buy US treasuries and cheap energy fuelling unconstraint growth, is away (all of that had been the drivers of a grossly mispricing of risks which led us to the current credit crisis). With a generation on its way to retirement, the coming rise of protectionism, the reduction of trade surplus of most emerging countries and the coming supply-constraint era of energy production, I see no reason to continue to live in a world with lowering long interest rates which has been the characteristic of the three latest decades of prosperity and surprised even Alan Greenspan (once again all of these developments could be the subjects of other posts).

So we are : no bull market in sight. Now the one million dollar question is : can we see the birth of a new bubble in the short term that can last until the true reality of the situation re-emerges ? We have one inflating in China, where government efforts to restart economy by forcing state-owned banks to lend have been redirected into stock market and real estate speculation and commodities stockpiling. Everyone is blessing the new figures of Chinese growth while the exports are still down.
Moreover, any new bubble would be followed by a rise of inflation expectations and a rise in energy cost (used as an inflation hedge by many players) which would add to the pain to the real economy, together with a rise in long terms interest rate prolonging the housing slump worldwide – leading to an unavoidable new crash.
And last but not least, a bubble need money to invest and especially from the people on the street. With the recent crash that burned half of the pension fund of many, the closure of a lot of hedge fund businesses (one quarter of them ?), where can those big guys find investors to follow them in any sustained bubble attempt ?
So the next market movement, although never can rule out a breakout to the 1000 – 1100 on the S&P, would probably be consolidation between 950 and 880 with a first objective at 910 (50% Fibonacci of this week rally or something like that).

This was my first post in the Margin Call Blog… more to come, stay tuned.

Welcome to the Margin Call blog

2009-07-19T21:07:00.000+02:00

This blog is not a trader blog. I am not a trader, I am not an economist either. No attempt to compete with the greatest economists blogs here. On the other side, I am an independent. I do not intend to sell investment advises through a monthly, subscription-based newsletter, I have no book to sell, nor any ties with a broker or a mutual fund. Thus this blog is free of any conflict of interest.

Not being a trader or a seasoned economist, yet, last year I had better fortune than most of the hedge funds and their army of traders, analysts and strategists. How ? By relying on the right source of independent information, reading the right people blogs and doing my own analysis and that is it.
Do not expect neither timely trading advises here in this blog, nor frequent news coverage or macroeconomics commentaries. Simply independent thinking and what I hope to be the right help to connect-the-dots. As usual as I am not an investment advisor and do not attempt to compete with anyone of them, please consider the content of this blog only for an educational purpose.

For the name of this blog a quick recap : a margin call is, when you trade with money that you do not own (i.e. “at the margin”), your lender asks you for more of yours either to cover a fall of the asset value of what you bought or because of the rise of risk perception.

Since the beginning of the financial crisis, world finance and economy have received a margin call. The fall of real estate has triggered a requirement for more money from already over-indebted households, and a lot of companies had similar requirement, as the perception of the risk of owning their debt suddenly increased. The economic agents, households, financial institutions have been trading at the margin for decades, sometimes even without realizing it and the associated risks.

More on that in a next post. Hope you will enjoy this blog.