The Yellow Peril grows up

Now that China has overtaken Japan as the second largest economy, I post the following poem, which was published in the Washington Post in 2008, without comment:

When we were the Sick Man of Asia,
We were called the Yellow Peril.
When we are billed as the next Superpower, we are called The Threat.
When we closed our doors, you launched the Opium War to open our markets.
When we embraced free trade, you blamed us for stealing your jobs.
When we were falling apart, you marched in your troops and demanded your fair share.
When we tried to put the broken pieces back together again, Free Tibet, you screamed. It was an Invasion!
When we tried communism, you hated us for being communist.
When we embraced capitalism, you hated us for being capitalist.
When we had a billion people, you said we were destroying the planet.
When we tried limiting our numbers, you said we abused human rights.
When we were poor, you thought we were dogs.
When we lend you cash, you blame us for your national debts.
When we build our industries, you call us polluters.
When we sell you goods, you blame us for global warming.
When we buy oil, you call it exploitation and genocide.
When you go to war for oil, you call it liberation.
When we were lost in chaos, you demanded the rule of law.
When we uphold law and order against violence, you call it a violation of human rights.
When we were silent, you said you wanted us to have free speech.
When we are silent no more, you say we are brainwashed xenophobes.
Why do you hate us so much? we asked.
No, you answered, we don't hate you.
We don't hate you either,
But do you understand us?
Of course we do, you said,
We have AFP, CNN and BBC. . . .
What do you really want from us?
Think hard first, then answer . . .
Because you only get so many chances.
Enough is Enough, Enough Hypocrisy for This One World.
We want One World, One Dream, and Peace on Earth.
This Big Blue Earth is Big Enough for all of Us.

Retirement: It's not just about money

When I left Mother Merrill in early 2007 and announced that I would be moving into early retirement about nearly 30 years in the business (which eventually drove me crazy), I quoted Todd Harrison in my farewell email to friends and colleagues entitled "Cam really is leaving to spend more time with his family":

I'm not going to say that success is insignificant, we know that's not true, but I can tell you, from experience, that if you look for happiness in a bank account, you're missing the bigger trade.

It appears that I am in good company of people wishing to slow down and to smell the roses. Stanley Druckenmiller recently shuttered his hedge fund following in the path of Richard Grubman (Highland Capital), James Simons (Renaissance Technologies), John Horseman (Horseman Global) and Timothy Barakett (Atticus Capital).

I recognized back then that life wasn't just about money (as important as it is). However, neo-classical economists have tended to focus on wealth creation as a source of growth for an economy. As good quantitative analysts know, optimizing a system based on a single factor can lead to unforeseen results (and possible policy mistakes).


The Paris Hilton effect
Here is an example. One of the biggest issues that faces the heads of wealthy families is the problem of instilling proper values in their children and how to teach them the value of a dollar. We saw that in spades during the dot com era when 20-somethings and 30-somethings working stiffs became multi-millionaires overnight. What message are you sending the kids when you can hop on the private jet and fly to St. Moritz for Spring Break? Do you let each of your children bring a friend along? What message does it send to your kids' friends and your neighbors?

If you don't think those are problems, then how do you prevent your kids from turning into Paris Hilton?


The Good Life
Now a MetLife study confirms my sentiments about the Todd Harrison quote. While wealth is important as a source of happiness, it’s not the only thing:

• Respondents define the Good Life in terms of the three Ms: Money (having enough), Meaning (time for friends and family), and Medicine (good physical and mental health).
• Living the Good Life is highly related with having a sense of purpose and this in turn is interrelated with “vision” (having clarity about the path to the Good Life) and “focus” (knowing and concentrating on the most important things that will get you to your Good Life).
• Meaning, closely associated with the importance of family and friends, remains the primary component of the Good Life for all age groups, despite instability in financial and other aspects of their life. People plan to spend time with family and friends above all else, regardless of age.

What’s more, the study found that these components tend to be stable and unrelated to age. You can have the Good Life whether you are 20, 50 or 70 if these things are in your life.


The changing face of retirement
As the Boomers age, there have been worried discussions about what happens when they find out they don’t have enough money to retire. Such discussions may be overly alarmist because they assume that money is the sole source of happiness.

According to an alternative view in The Economist, saving enough money to retire may not be realistic. If you are trying to optimize Happiness instead of Wealth, then a better way might be to re-define retirement. Instead of an abrupt exit from the work force, consider part-time work:

For us, retirement is a choice—and because we enjoy our jobs and they’re not physically taxing, retirement is not something we tend to embrace. But most people are not so lucky. Even if they like their jobs it, the work may be too physically demanding to continue into old age. A colleague of mine was often told by his father, “Get an education so you can get a job where you use your brain; it’s the best insurance against getting injured.”

A phased transition from full to part time work is possible for some people, particularly in an age when medical science has advanced and so has life expectancy.

As we live progressively longer we must also rethink our retirement expectations. Retiring at the same age that your parents did, or earlier, can no longer be the expectation, or at least not at the rate we are saving. True, working to age 70 will be tough or impossible for some people and it is expensive for employers. Meanwhile, part of the justification for a later retirement age is longer life expectancy, but low income people who worked in hard labour often die younger. In principle we could index the normal retirement age to different demographic life expectancy—so people will have different ages when they can collect full Social Security. But politically that would be a mess, especially because mortality rates are so race-specific. That's why retirement may need to come to mean something different than it currently does. Retirement may not be an abrupt exit from the labour force, but a slow phase out starting with part-time work.

Bond Market 1, Stock Market 0

Recently some have observed that the US stock market and bond markets have rallied together - an unusual condition. The Economist/Buttonwood blog wrote:

This reminds me a bit of the late 1990s when, as a tech sceptic, I wondered why the stockmarket kept surging to stratospheric valuations. Whatever the headlines the market went up. Good news on the economy meant profits would be strong while bad news meant that central banks would cut rates, and thus profits would eventually be strong.

Fast forward to 2010:

[T]he bond market is surely betting that the Fed's actions won't work and that Japan is the template; the equity market is betting that the Fed will be successful and the Goldilocks economy will return. 

Recall James Carville's famous comment that he wanted to be reincarnated as the bond market so that he could intimidate everybody - that’s because the bond market is usually right. In light of last week's market action and the appearance of the Hindenberg Omen, the bond market seems to have scored.

Incidentally, I see that Barry Ritholz at The Big Picture also commented on the stock vs. bond market tug of war by calling the bond market "adult supervision."

Could commodity prices be in for a downdraft?

Several months ago Gluskin Sheff chief economist David Rosenberg pointed out that the Shanghai stock market appears to lead commodity prices by about four months.

Looking at the chart below, the Shanghai Composite broke down in mid-April. Fast forward four months to today and factor in yesterday's market action, not only in stocks but in commodity prices. Also consider that wheat prices, which had gone parabolic, had been pulling back for about a week, you have the makings of a serious downdraft in commodity prices.

I don't know if the four month Shanghai-CRB relationship is spurious or not, but this is a fascinating theory that can be tested in real-time.

What happens when you ARE the market?

I see that the folks at US Commodity Funds, who brought us the tremendously popular ETFs USO and UNG, is launching an ETF that is designed to combat the return eroding contangoes observed in many commodity futures. The new fund is called the United States Commodity Index Fund and will track the SummerHaven Dynamic Commodity Index. The Index will re-balance monthly and hold 14 out of a possible universe of 27 commodity contracts on an equal-weighted basis. The selection will be strictly rule-based:

USCI is based on a simple but powerful investment thesis: historical data shows that portfolios comprised of commodities trading in backwardation tend to perform better than broad-based commodity baskets or commodities for which futures markets are contangoed. The idea behind USCI is that the optimal form of commodity exposure is achieved through positions in backwardated markets or markets that exhibit the least degree of contango.

An explanation: When long-dated futures are trading above the current spot price, the market is considered to be in contango. When then are trading below spot, the market is said to be in backwardation.

Sounds great? Not!

I am sure the backtests worked really well but this is a case of quants gone wild. No doubt, US Commodity Funds hopes that the success of the new ETF will equal or exceed the popularity of USO and UNG. Were this to happen, the buying pressure put on some of these commodities, which can be quite thin and illiquid, would create enormous return eroding price distortions.

As an aside, you are just begging for the Street to front-run you given the rule-based index construction approach – not a good idea.


Too many ETFs?
In early July, TickerSense reported that the number of US-listed ETFs that they track went over the 1,000 mark. Do we really need that many ETFs?

Are they distorting the market and market liquidity?

Could less sophisticated investors be fooled into believing that an ETF representing a narrow, but sexy, segment of the market be more liquid than it really is? Consider this recent Van Eck Global filing for a Minor Metal (read: rare earths) ETF.

Enough is enough. Some of these ideas are ill considered and are accidents waiting to happen.

The Inflation-Deflation debate continues

As we wait for the FOMC statement, I see that the inflation-deflation debate is continuing. On the deflation side of the debate, the economy remains anemic and Nobel Laureate Joseph Stiglitz is calling for more stimulus. Moreover, Pimco head El Erian warned of deflationary risks in the US economy.

On the other hand, we have the wheat crisis in Russia, which has pushed up food prices and is raising the specter of commodity inflation.


A volatile decade
Which camp is right and what can investors do?

My answer to the first question is “I’m not sure.” However, I do agree with Simon Johnson, who stated that:

The major risk faced by the world economy is not stagnation year-in and year-out, but rather an unstable credit cycle that produces apparent “growth” – perhaps even high recorded growth – in some years for the United States, but then leads to financial crisis, repeated recession, and very little by way of sustained growth. US GDP in real terms is currently at about the same level now as it was in 2006. (Real GDP, annualized, was around $12.9 trillion in the first quarter of 2006 and $13.2 trillion in the second quarter of 2010; see Table 3B in the July 2010 BEA report).[3]

For buy and hold investors, this may mean a decade of low but volatile returns, which is a possibility that I wrote about before here. However, Johnson offers a ray of hope:

Japan’s lost decade in the 1990s was not a sequence of years with zero growth – there were notable expansions and contractions, with high rates of growth in particular quarters and even some years when it seemed that the corner had been turned. Lost decades are evident only in retrospect. The US is currently on track for “losing” at least half a decade of growth (from the beginning of 2006 through the end of 2010).

In other words, there would be significant cyclical ups-and-downs under such a scenario and it would be possible to trade the swings using trend following models such as my Inflation-Deflation Timer model.

An unbalanced China bet?

I have been somewhat skeptical of the current stock market rally but I haven't quite been able to put my finger on the reason - until I looked at the market relative charts to see where the leadership has been coming from.

The downdraft that ended in early July was based on a double-dip recession scare. If Mr. Market truly believed that the recovery was real, then we should see leadership from sectors such as Consumer Discretionary stocks. The chart below shows the relative performance of the Consumer Discretionaries (XLY) against the market. The sector has been fairly flat against the market since early July, indicating that market leadership isn't coming from expectations of a revived consumer.

What about the Financials? This is a sector that has been badly beaten up since the Lehman Crisis and was in need of rescue. Did the Financials lead us up in this rally? A glance at the chart below says "no". In fact, Financials remain weak and in a relative downtrend versus the overall market.

If the leadership isn't coming from the cyclical consumer or beaten up Financials, then where is it coming from?

The answer is in Industrials, which is tilted towards capital goods:

,,,and the resource sector such as Energy (shown below) and Materials (not shown):

A Shanghai relief rally
Under more "normal" circumstances, a market rally would be predicated on a reviving consumer or a recovery in the financial sector. Instead, we have a rally led by hard assets and capital goods. Digging deeper, this rally tracks the rally in the Shanghai Composite, which bottomed in early July and is showing some signs of life.

This suggests that US equities are rallying based on the belief that China, which has been the last hope of growth in a growth starved world, isn't going to experience a hard-landing despite the bad loan risks in their financial system. In the meantime, indicators such as the ISM Manufacturing Index continue to weaken and so does the much watched ECRI WLI. While a soft landing in China may be a relief to investors, a scenario like that is highly unbalanced and does not provide the basis for sustainable global growth.

More on Iran, China

A couple of brief follow-ups to previous posts:


Rumors of war
Further to my recent post on the possibility of war as the reflationary trade, the Fabius Maximus blog pointed out that VIPS, a group of senior people within the US intelligence community, ihas published an open letter to Obama warning about an Israeli strike on Iran:

We VIPS have found ourselves in this position before. We prepared our first Memorandum for the President on the afternoon of February 5, 2003 after Colin Powell’s speech at the UN.

We had been watching how our profession was being corrupted into serving up faux intelligence that was later criticized (correctly) as “uncorroborated, contradicted, and nonexistent” — adjectives used by former Senate Intelligence Committee chair Jay Rockefeller after a five-year investigation by his committee.

As Powell spoke, we decided collectively that the responsible thing to do was to try to warn the President before he acted on misguided advice to attack Iraq. Unlike Powell, we did not claim that our analysis was “irrefutable and undeniable.” We did conclude with this warning:

“After watching Secretary Powell today, we are convinced that you would be well served if you widened the discussion … beyond the circle of those advisers clearly bent on a war for which we see no compelling reason and from which we believe the unintended consequences are likely to be catastrophic.”
http://www.afterdowningstreet.org/downloads/vipstwelve.pdf

We take no satisfaction at having gotten it right on Iraq. Others with claim to more immediate expertise on Iraq were issuing similar warnings. But we were kept well away from the wagons circled by Bush and Cheney.

Sadly, your own Vice President, who was then chair of the Senate Foreign Affairs Committee, was among the most assiduous in blocking opportunities for dissenting voices to be heard. This is part of what brought on the worst foreign policy disaster in our nation’s history.

We now believe that we may also be right on (and right on the cusp of) another impending catastrophe of even wider scope — Iran — on which another President, you, are not getting good advice from your closed circle of advisers.

They are probably telling you that, since you have privately counseled Prime Minister Netanyahu against attacking Iran, he will not do it. This could simply be the familiar syndrome of telling the President what they believe he wants to hear.

Quiz them; tell them others believe them to be dead wrong on Netanyahu. The only positive here is that you — only you — can prevent an Israeli attack on Iran.

I have had some feedback on my post, some of whom disagree with my assessment that war would be bullish for the markets. Let me re-phrase my beliefs. War would likely be bearish if America was to spend more blood and treasure getting caught in another quagmire. War would be bullish for the US economy if Americans followed the 19th Century imperialist model of "looting" conquered lands - which could happen if Americans controlled the major oil producing regions in the Middle East. I am not passing judgment on whether such a course would be right or wrong, but just stating my assessment of the likely consequences of war.


China moves up the value chain
Further to my last post and essay on the very long view on China, I see that Patrick Chovanec and I are on the same page about rising labor costs in China and China moving up the value chain:

The Chinese economy is changing. There’s no question that companies that continue to rely on cheap labor to produce low-value, commodity goods — like those ones Andrew describes in his article — will increasingly feel the squeeze. As forward-looking companies pay more to deliver greater value-add, the opportunity cost of employing labor rises. That’s good for the economy, and for standards of living, but it means companies that remain stagnant must pay more just to do what they were already doing. With razor-thin margins based purely on eking out lower costs, many will go under.

Materialistic China

A couple of weeks ago the New York Times published an article about the materialistic young in China, as exemplified by the behavior on dating shows. The poster child for Chinese materialism turned out to be a contestant on the popular show If You Are The One (非城勿扰), who was asked if she would like to go for a bicycle ride, she responded "I’d rather sit and cry in the back of a BMW" and be unhappy than be poor and happy. The authorities responded with heavy handed censorship:

Late last May, central government propaganda officials issued a directive calling the shows “vulgar” and faulting them for promoting materialism, openly discussing sexual matters and “making up false stories, thus hurting the credibility of the media.”

So the dating show, and others like it, got a makeover. Gone are fast cars, luxury apartments and boasts of flush bank accounts. Now the contestants entice each other with tales of civic service and promises of good relations with future mothers-in-law. One show now uses a professor from the local Communist Party school as a judge.

There was more to that story. It turned out that the "contestant" modeled lingerie. It appeared that there is a problem with many TV dating shows that the contestants were either fake and were either assoicated with the show in some way or models promoting themselves.


The very long-view on China: Beyond the materialism
Rather than going tut-tut or about the rise of consumerism and materialism in China or commenting on the effects of rising affluence, it is instructive to think about this as an unwanted effect of the one-child policy, which I posted before here. It is further instructive to think about the demographics effect of China's aging population and think about the very very long-veiw on China, which is the subject of an article that I recently wrote about here.

The (market) spirits are willing, but the fundamentals are weak

Recently Barrons asked the question: “Do you believe in technicals or fundamentals?” The article pointed out that while the technical picture looks bullish, the fundamentals remain weak and caution is warranted.

I agree that the technical picture looks quite positive as the bulls seem to have regained their footing. On the other hand, respected investors and analysts such as John Hussman to David Rosenberg have been warning about the deteriorating economic backdrop.

The price of economically sensitive Dr. Copper tells the story of improving technical picture. As the accompanying chart shows, trend following models experienced a “dark cross” (circled), which point to a downtrend when the shorter 50-day moving average crossed below the longer 200-day moving average. However, copper prices have rallied significantly since that event, which points to further short-term price improvement.

On the other hand, Gluskin Sheff chief economist David Rosenberg wrote on July 27, 2010 (free registration required) that “the technical picture has improved. The data have really been unimpressive even if not horrendous. And I think we have the potential for a lot of disappointments in earnings to come as the plays on ‘domestic demand’ are in the offing.”

SocGen strategist Albert Edwards likens the current situation to Japan’s Lost Decade(s):

We are at the most dangerous stage in the Ice Age – the ‘post-bubble cycle’. For although it is clear that leading indicators have turned downwards, the choir of sell-side sirens is singing its song of reassurance. The lesson from Japan was that once the cyclical rally is over, any downturn in the leading indicators should find you stuffing beeswax in your ears to block out that lilting melody so as to avoid the jagged rocks of recession.

In the end, it depends on one’s time horizon and risk tolerance. My inner investor remains extremely cautious and looks for market strength to lighten up positions. My inner trader, on the other hand, tells me to go with the flow and stay on the bullish momentum train.

The “surprise” reflation trade?

A couple of weeks ago I wrote that war might be the surprise way for the US to dig itself out of a debt hole. After all, investors tend to care less about mundane things like debt service ratios when the shooting starts – and who knows what kinds of assets the winner may gain in a war?

The hawks circle
Avner Mandelman, who has been warning about the possibility of war, wrote on the weekend about the beat of war drums:

[L]ast month the U.S., British and French navies held an unprecedented joint exercise in the Mediterranean, and right after, the U.S. aircraft carrier Truman and its 10 accompanying battleships crossed the Suez Canal to join the two other U.S. carrier groups already in the Gulf. Even more interesting, two weeks later an air caravan of American and Israeli cargo planes landed in Azerbaijan, downloading "equipment," which caused the Iranians to protest loudly and go on war alert.

Such force concentration near the oil fields doesn't mean a conflagration is imminent, but it does mean the risk of one has gone up, with possible investment implications.

Michael Hayden, former director of the CIA, believes that the march to war with Iran is “inexorable”. Consider these two interpretations on his interview with CNN’s State of the Union. The first is from the viewpoint of the hawks from DEBKA and the second from the doves at the Fabius Maximus blog.


A bullish fat-tailed event
For investors, war would be the ultimate reflation trade that would make the bears really run for the hills. This is a possible fat-tailed event that we need to keep an eye on. While coverage is not easily found in the mainstream press, it is possible to find sources such as DEBKA, which is good source of information (or disinformation, depending on how you view things).


Don't just react to newsflow, analyze
Readers should be warned that DEBKA has a Likud Israel-is-under-continual-siege mentality and is prone to exaggeration as it has falsely pounded the war drums before. For example, this recent story about the deployment of a third US carrier opposite Iran sounds alarming. Upon closer examination, the third carrier turns out to be the USS Nassau, which is an amphibious assault ship carrying marines rather than a large Nimitz class carrier such as the USS Dwight D. Eisenhower or USS Harry S. Truman, which are reportedly deployed in the theatre.

Please be reminded that the United States has heavy troop presence in Iraq and Afghanistan and it would not be overly unusual to have one or two large Nimitz class carriers in the region.

Investors should be prepared for the possibility of war, but analyze the situation carefully before jumping to conclusions.

So you think you can be a portfolio manager?

The task of managing portfolios isn't as easy as it seems. Not only do you have to think about issue selection, you also need skills like portfolio construction and trading. Over the years, I have seen very smart and experienced sell-side analysts who have had great difficulty making the transition to the buy-side and portfolio management.

David Merkel at Aleph Blog wrote a terrific series called The Education of a Corporate Bond Manager (see Part 1, part 2 and part 3) that addresses many of these problems. For example, Merkel discusses the problems of putting together a portfolio when time is limited and there is no time for analysis:

But when the market was hot, and deals would close within an hour, I would work differently. When the deal would come, I would put in for bonds, so that I would get some allocation. I would ask for the high end of what I would normally ask for, knowing that I would get scaled back considerably. Then I would send the details to my credit analyst, telling them that if they did not like the company, I would sell the bonds.

Eventually, most of my analysts during the times when the market was hot would come to me and say, “How can you put in for bonds without an opinion from us?” First I would reassure them, and tell them that I valued their opinions, and that I would not hold onto a bond permanently unless they liked it. I would sell all bonds they did not like, but when the technicals favored it, within a few months.

And the problems with trading:

But I started selling away, and began to learn the art of price discovery. When you want to sell a bond, you first have to look at what investment banks ran the books of the deal. There is an unwritten rule that if they play that large role in origination, they have to make a market in the bonds thereafter.

I also wrote a series called What do you do after you've made your picks that looks at the problems from the viewpoint of an equity manager (see Part 1, part 2 and part 3).

Go and read them and you'll get some perspective.

How diversifying are commodities?

I would like to address the issues raised by my last post about buy-and-hold vs. dynamic asset allocation about the diversifying properties of other asset classes, specifically commodities.


Are commodities diversifying?
AllAboutAlpha recently wrote about the death of commodities as an asset class. One of the studies cited was from RS Investments, where they show commodity prices are increasingly correlated to equity returns.

AllAboutAlpha concluded that commodities remain a good source of diversification since they are highly correlated to inflation.


One giant risk trade
Izabella Kaminska at FT Alphaville addressed the commodity diversification issue slightly differently by observing that commodities are increasingly correlated to stock market returns because of the stampede of institutional funds going into the asset class. She went on to discuss the lengths that some dealers and institutions have gone to in order to minimize the loss of returns from rolling the contango.

The rising correlation to equities and correlation to inflation both point to the same thing. The commodity trade has become just a risk trade.

When I view commodity prices through the inflation-deflation macroeconomic lens in the Inflation-Deflation Timer model and put it on the risk-safety axis, commodities have become the risk, or inflation/reflation trade. The other end of the deflation, or safety axis is occupied by the US Treasury long bond. By the way, equities are correlated with commodity prices because they, too, represent the risk trade, or reflation trade, albeit in a less volatile fashion.

Are commodities a good diversification building block? I am afraid not. They are just an extension of the reflation or risk trade represented by equities.

How to cope in a low-return environment

MarketWatch published an article last week discussing the rise of trend based market timing strategies, compared to the more traditional buy-and-hold approach to investing. I also covered the same issue when I posted that we may have to wait eight years for a new equity bull to begin.

To recap, we may very well be in a secular bear market, where returns are roughly flat as illustrated by the chart of the DJIA below.

Zero return with portfolio volatility?
Let’s do a back of the envelope calculation. The stock market’s dividend yield is around 2% and the 10-year Treasuries yield around 3%. Assume that stocks have no capital appreciation over the next 5-10 years, the expectation of return of a buy-and-hold balanced fund is going to be around 2.5%, regardless how you play around with the asset mix decision.

Don't forget layer on the transaction costs and fees. After factoring in trading costs, which can easily be 1% or more for individuals, and investment management fees (conservatively estimated at 1-2% for an active solution, under 1% for passive solutions), the investor is left with little or nothing to show for his efforts, except for the volatility in his portfolio.

Why not just sock the money into a savings account?


Yield at a reasonable safety margin
To cope with a low return environment, the first-order solution for the buy-and-hold crowd has been to seek out yield. But there is no free lunch here either. Higher yield comes at the price of credit risk and credit risk could blow up in our faces in the current fragile economic environment. Some investment managers have sought to mitigate that with the concept of yield at a reasonable safety margin, which is not a bad solution under the circumstances and the constraints of a fixed asset allocation.


Dynamic asset allocation using trend following principles
My solution, along with some others cited in the MarketWatch article, is to trade the swings. The swings can be considerable – witness the trough-to-peak behavior of stocks since the March 2009 bottom.

I am not alone in my choice of modeling platform. My Inflation-Deflation Timer model is based on trend following principles, as applied to various commodity prices. The MarketWatch article cites others who use similar techniques. Mebane Faber uses similar kinds of principles to limit losses in asset allocation.

Coping with a low return environment is hard. Preserving financial staying power is of paramount importance under these circumstances. For those who believe in the static buy-and-hold asset allocation approach to investing, reaching for yield as a source of stability can be a reasonable approach if credit analysis is done properly. I happen to be in the dynamic asset allocation camp, where I believe the returns can be considerably higher given the likely volatility of the financial markets.

The erosion of American competitive advantage

The news flash came across my desk: China's leading credit agency downgrades the US, Britain and France from AAA. This news is undoubtedly a sign of things to come. The question is, can America retain its status as a leading economic power?

The news is grim. I have written before about the analytical framework of deficit reduction. That kind of macroeconomic adjustment is only effective if Americans retain their underlying competitive advantage. John Hussman wrote this week that the basis of American competitive advantage rests on superior physical capital and human capital [emphasis added]:

The main source of this difference in productivity is that U.S. workers have a substantially larger stock of productive capital per worker, as well as generally higher levels of educational attainment, which is a form of human capital. This relative abundance of physical and educational capital has been a driver of U.S. prosperity for generations. Neither advantage in capital, however, is intrinsic to American workers, and it will be impossible to prevent a long-term convergence of U.S. wages toward those of developing countries unless the U.S. efficiently allocates its resources to productive investment and educational quality. This is where our policy makers are failing us.

The US is squandering its lead on both fronts. Instead of investing on productive physical capital, we have seen excessive malinvestment leading to bubbles in technology, real estate and finance over the past couple of decades. The internet and real estate bubbles were plain to see.

As for finance, what does all of the malinvestment of human talent into Wall Street say to the world? Despite the ineffectual efforts at financial regulation, American remain in denial about the role of finance in society. The news of the Alan Greenspan chair at NYU is just another sign of denial.

‘Nuff said.


Trouble in higher education
In addition, there seems to be signs of trouble in higher education, which is a key driver of the productiveness of human capital.

Firstly, the lead in education isn't what it used to be. A recent study concluded that elite universities are eroding their competitive edge. I had blogged about a Tiananmen Square protester returning to China for the sake of his children because of the lower quality the Canadian education system, which from first hand-experience equivalent or slightly higher quality than the American system.

As well, the cost of a university education is spiraling out of control. Consider Rolfe Winkler’s comments:

The market for college education looks a lot like the market for houses circa 2006 – very bubbly. And the reason is similar: There is too much credit.

Colleges can keep raising prices, despite the recession, because the government keeps lending students more money to pay them.

Rising prices and ample credit to finance purchase – does that sound like anything we saw before, such as the housing market? Carpe Diem shows this chart to illustrate how fast prices have been rising and went on to warn of a bubble in higher education:

Malinvestment in physical capital and failing human capital...there will a time to pay the piper and that day may be coming sooner than anyone expects.

A creative war to dig out of the debt hole

Since the G20 meeting there has been a lot of hand wringing over the level of sovereign debt. Calculated Risk posted alarmingly about the frequency of sovereign debt in the past.

Defaults tend to come in clusters, and the behavior of lenders often changes substantially after defaults. In the Volatility Machine, Michael Pettis asserts that sovereign default contagion follows predictable patterns, and that contagion is primarily due to investors in the first defaulting country also having investments in other countries which are vulnerable. This is especially the case with leveraged investors.

So far, investors have firewalled many of these debt default concerns in the US. In fact, every time something blows up somewhere, Treasuries have rallied. Can this state of affair continue indefinitely?

The answer is no. The United States has to find a long term solution to its problem of growing debt. But how serious is this problem? Deus Ex Macchiato posted a chart of the British debt-to-GDP ratio for a very long term perspective:

The first peak in debt to GDP occurred just after the Battle of Waterloo in 1815 and the second just after the end of World War II in 1945. Some market observers have pointed out that the US debt to GDP ratio has been higher than they are today. It is also instructive to go back to an earlier era to learn about how Britain dug itself out of her debt hole after the Napoleonic Wars.

The answer is India. It began with the British East India Company rule of India and progressed to the British Raj. Simply put, the British went to India and took things as part of their colonial adventures.

Could the US go down the same path? Tim Knight at the Slope of Hope posted that financial crises and crashes have led to wars. While the causation and historical links between financial stress and war look a little tenuous, there is a kernel of truth to the story.

War is a possibility, but not a highly probable one. Avner Mandelman has written about this very issue (see Watch out if a cash-poor U.S. seeks new spoils and Austerity in the West? Not if the generals can be useful).

During the 1990s, I said privately that the solution to Japan’s Lost Decade was to land 100 of the Japanese Self Defense Forces on the disputed Kuril Islands. The effects would be highly reflationary for Japan's economy. I also blogged on April Fool’s Day about A modest proposal to restore America.

Ironically, war would likely be bullish for the markets, though it is not a possibility that most of us would like to contemplate. It is nevertheless a path that we have to allow for in our investment planning scenarios.

Wait 8 years for a new bull?

USA Today recently asked How will Baby Boomers' retirement affect stocks?

I may have an answer from academia. Further to my post about anxious and volatile markets, John Geanakoplos, co-author of the paper entitled Leverage cycles and the anxious economy, also wrote another intriguing paper called Demography and the Long-Run Predictability of the Stock Market, with Michael Magill of the University of Southern California and Martine Quinzii of the University of California at Davis.

In this study, Geanakoplos et al related demography to long-term stock returns. They found that P/E ratios were correlated to the ratio of middle-aged people to young adults, otherwise known as the MY ratio. When MY rises, the market P/E will tend to rise and when it falls, P/Es tend to fall.

If the conclusions of the study are correct, then we should see a continued fall in P/E ratios with a long-term bottom in stock prices forming about 2018, or eight years from now.

Back to the '70s
Recall that the previous anxious markets paper that I cited indicated that current macroeconomic conditions called for volatile markets in the aftermath of the economic crisis. This latest paper suggests that we are gripped by a secular bear market until 2018. Putting it all together, the current environment is reminiscent of the 1970s, which was gripped by inflationary fears, slow growth, volatile markets and flattish equity returns.

The chart below of the Dow Jones Industrials Average shows that, since the Second World War, the market has been gripped by two episodes of secular bull markets to be followed by secular bears. The secular bulls were characterized by a substantial advance lasting over a decade while secular bears were marked by sideways markets lasting over a decade.

These studies are also consistent with the big bear charts at dshort.com, where Short shows the progress of the stock markets following the Great Depression and Japan’s Lost Decades.

Flat markets mean flat returns
Investors who accept such a scenario need to change their approach to investment policy. The buy-and-hold approach, long espoused by investment advisors during bull markets, will result in subpar returns in range-bound periods. Flat markets mean flat returns.

During secular bear markets characterized by flat returns, investors need to use dynamic asset allocation techniques such as the Inflation-Deflation Timer model to capture the swings of a flat market.

Dr. Copper teeters over the abyss

The market action last week was dominated by concerns of a double-dip. Indeed, the week began with John Hussman warning of a double-dip recession and ended with John Mauldin's hand wringing over the NFP release.

Dr. Copper, one of the most economically sensitive of commodities, is curiously showing weakness but hasn’t fallen apart. This is an indication to me that it may be a little early to over-react to recessionary fears.

By contrast, the SPX has shown a greater degree of weakness than copper. While the red metal is in a downtrend, it hasn’t even tested major support levels. By comparison, equities sliced through support like a hot knife through butter.

In fact, the entire commodity complex is showing the same pattern as copper – weakness but no freefall.

Apocalypse not yet
Does that mean all is well?

Not quite. Take a look at the copper to SPX ratio. While the ratio is indicating a near-term positive relative performance by copper, the ratio is displaying a rounding inverted saucer top pattern which is indicative of a long term decline.

These conditions are consistent with the readings of my Inflation-Deflation Timer model, which remains in neutral but perched at the edge of a deflation reading, which would be indicative of a 2008-style panic. The Inflation-Deflation Timer model is a trend following model, which can be late in calling economic trends.

These conditions are also consistent with John Hussman’s earlier essay outlining the tripwires of a double-dip recession. The only sign that remained to call for a full blown double-dip recession was the ISM Index at or below 54. The latest release of the index came in at 56.2, declining fast but not quite at 54 yet. Hussman did note, however, that the ECRI Weekly Leading Indicator, which has been in freefall, is highly correlated with ISM with a lead time of 13 weeks - and that's why he made the double-dip recession call.

Overall, I am tilting towards the views of Barry Ritholz, who wrote that "We do not rule out a double dip or a recession in 2012 — we simply do not have sufficient evidence to draw that conclusion."

Right now, my inner investor is extremely cautious and defensive in light of the risks of a hard landing. On the other hand, my inner trader tells me that a waterfall decline is not an immediate threat, but to be prepared for a short and sharp relief rally to lighten long positions and/or to initiate short positions.

Long-term bullish factors for oil

The headline on Marketwatch blared that the BP spill may lead to higher oil prices. Indeed, Jeff Rubin has expressed similar sentiments about how the Deepwater Horizon disaster is likely to affect the supply situation for oil (see examples here and here).

I agree wholeheartedly. My latest monthly comment for Qwest Investment Management details these same supply concerns. I would also add the possibility of higher heating demand from a global cooling cycle.

There is a controversial view that solar cycles are responsible for the warming and cooling cycles on earth. The English astronomer William Herschel noted a relationship between sunspot cycles and wheat prices and that link has been confirmed by other researchers.

Right now, the sun is undergoing an extraordinarily quiet period and tracking previous periods of global cooling. If the climate were to cool, which would raise heating demand, and oil supplies fall because of higher operating and environmental standards – look out!

Come and read it all here.

Not regulation, but proper structures

There has been a lot of discussion over financial regulation lately. My view has always been that trying to regulate financial entities is like herding cats. Just when you think you’ve got them rounded up, one or two get away and trouble starts all over again.
Consider this exchange with a hedge fund manager about how clueless people participated in bubble creation [emphasis added]:

HFM: Look, bubbles create other bubbles, they’re like derivative bubbles, so to the extent that there was a bubble in credit or a bubble in the mortgage market, that created a bubble for people who could trade those products. There was a misallocation of resources not only into mortgages, let’s say, but also into the trading of mortgages, and it sucked talent into those areas that probably should be deployed other places. And the way talent gets sucked into those places is by a price signal, the compensation going out. So what was happening was that the pay scale for finance was just—incredibly out of whack. You had guys who were literally just a couple of years out of college, maybe they’d done a year or two at an investment bank, making several hundred thousand dollars a year doing pretty low-value-added Excel-modeling tasks…

It was kind of crazy what people were being paid. And for the more senior people, the kind of deals they were getting—because their pay tends to be not just a number range but a percentage of the profits they generate—they were getting very high percentages of the profits, and very high guaranteed income. The decision to pay those kinds of numbers was motivated by the fact that other places were paying those kinds of numbers, and their ability to pay those kinds of numbers was motivated by the fact that there were huge amounts of assets coming into hedge funds, and hedge funds are able to charge a management fee for the assets under management. So if you had tons of assets coming in, you needed people to manage those assets, you had to get quality people, you had a ton of money to spend, and everybody was looking for people who had a resume that singled them out, or that identified them as qualified to work at a hedge fund—there was just tremendous competition for those people, and it drove prices to ridiculous levels. It changed people’s attitudes—there was a palpable cockiness that one sensed from employees. And there was a lack of distinction I think between people who were really good, who you would want in any environment, and people who you could just fill a seat with because they had a resume that stamped them as minimally qualified.

There are a lot of very creative people working on Wall Street and they will engage in regulatory arbitrage. If you try to regulate one activity, e.g. how hot IPOs are distributed, that particular problem will go away but that creative talent will go elsewhere to do something else that creates the next regulatory problem.

It’s not that I am ideologically opposed to regulation, but in this case a heavy-handed regulatory approach just doesn’t work. The correct solution is to create the right operating structure for the financial marketplace:

1. Complete and timely disclosure; and
2. Symmetric incentives.

The disclosure part is easy to understand. Complete and timely disclosure doesn’t allow one side to stack the deck.

The second part is a little bit more subtle. The current structure at investment banks aren’t incentivizing people to get rich slowly by building long-term relationships, but to get rich quickly by doing the trade while ignoring the long-tailed risks that may come with the trade. That’s an asymmetric incentive structure. One very simple solution is to bring back the partnership investment bank. Barry Ritholz and I are on the same page on this issue and he correctly points out that none of the Wall Street partnerships got into trouble in the last financial crisis.


In praise of good government
While I am disinclined to regulate, it doesn’t mean that government is inherently bad. In fact, good government can be a positive force in creating the structure for economic growth.

For the Tea Partiers and Libertarians out there, consider this. Consider this modern account (from the same aforementioned hedge fund manager) of what happens when you don’t have good government:

[T]here’s something very attractive from an investment standpoint of going to a place like Lagos... You’d go to an office building or a hotel and in the course of the day the power goes out six times and the generator kicks on to power the building, and that generator is powered by diesel, and you see all these fuel trucks all over the place that have to bring diesel to fuel the generator, and the generators are noisy and loud. You’re like, “Wow, there’s an obvious opportunity here. Somebody should build a reliable power plant! It would just be tremendous, a tremendous economic efficiency, because you wouldn’t need all these diesel trucks zooming around, you wouldn’t need all these generators…”

Then you realize that the place sounds like a scene from The Sopranos:

But then you realize that it’s not like they can’t figure this out. It’s not like they don’t get the fact that it’s pretty annoying that the power goes out six times a day and it’s pretty annoying to have six fuel generators humming all the time. The reason investment doesn’t happen is because it’s in some powerful person’s interest that it not happen. There’s some guy who controls the diesel trucks who makes tons of money from being a diesel distributor, and there’s a guy with all these generators who would be out of business if power plants were built, and he stands in the way.

In fact, the structure of the fictional Soprano mobster family sounds an awful lot like the feudal states of a bygone era, where the baron (don) lorded over his estate surrounded by his knights (his "crew" of “made men”). But wait, are feudal states really from a bygone era? Wasn’t Ferdinand Marcos just a king by another name? What about Dear Leader Kim of North Korea? Consider this account from Foreign Policy about what is clouding our perception of Afghanistan:

Western observers attempting to come to grips with Afghanistan's fragmented state authority also find themselves drawn to other aspects of the medieval era, a period in which leadership in Europe was personal rather than bureaucratic and the state's power to impose its will quite limited.

The difficulty for a monarch was that the resources remained in the hands of his vassals, who then acted in their own interests. The rise of centralized states in Europe in the 16th through 18th centuries finished a process by which monarchs gradually centralized power and dispossessed their feudal nobilities. Then, in the beginning of the 19th century, the rise of the European nation-state took this process a step further and dispossessed the monarchs while keeping intact the centralized administrations they had built.

Foreigners encountering Afghanistan in the post-2001 era saw this devolution of power as an example of state failure. Many of the multiple competitors for legitimate authority at the local level had no desire to participate in politics in a state-centered system. Autonomous tribes and ethnic groups, local militia commanders, criminal syndicates, and even blood-feuding families sought to resist state power, but they did not seek to overturn or replace it. This arrangement is analogous to medieval Europe, where kings were frequently also unable to maintain a monopoly on the legitimate use of violence, but were still able to retain their thrones.

Is that what we really want? Be careful about what you wish for when you want the government off your back.