Asia’s Policy Arbitrage, Phisix And The Bubble Cycle

``There is room for investors to start celebrating ‘neither too hot nor too cold’ again, when they stop fretting about tightening and before they start worrying about bubbles again…All roads still point to an asset bubble in China, most particularly if the currency’s appreciation continues to be suppressed.”-Christopher Wood, CLSA (Bloomberg)

The recent Fed’s action had not been well taken by Asian markets.

Although Asia’s markets had been up for the week, they have immensely underperformed their regional and emerging market counterparts.

It looks as if Asian markets may have overestimated on the impact of the US discount rate hikes and may equally underestimated the Fed’s future actions.

Figure 4: Stockcharts.com: Discount Rate Troubles?

The fall of Asian markets, including the Philippine Phisix (main window), Japan’s Nikkei (Nikk) and Dow Jones Asia ex-Japan (DJP2) seem to coincide with the Fed’s ‘surprising’ announcement.

Perhaps it maybe just an excuse to retrench or perhaps there could be other factors involved. The week long absence of China’s market, which celebrated her Lunar New Year of the Tiger, may have also been a factor.

Nonetheless, surging commodities prices appears to have turned the tide for the Baltic Dry Index (BDI) an index which tracks shipping prices for dry goods. As for the latter’s sustainability, this has yet to be confirmed over the coming sessions.

Our guess is that if China’s markets have indeed bottomed as we suspect it has [see last week’s A China Bubble Bust Is Unlikely Yet], then the BDI index we suspect will rise in congruence to rising key stockmarkets worldwide.

Since China’s markets has recently shrugged off the recent second round of increase in reserve requirements for her banks, her markets may have begun to digest the “exit” strategies employed by their local central bank.

For us, Asia and emerging markets are likely to be more receptive to the incentives brought about by the steep yield curve to keep asset prices afloat than to developed economies.

So it seems a bizarre reaction that we read from a local official of our domestic central bank, the Bangko Sentral ng Pilipinas, to extol on the Fed’s increase of its discount rate as helping out local policies by “narrowing of the [interest rate] spread”, “this gives us [BSP] additional space before we implement our own exit plan” said BSP Deputy Governor Diwa Guinigundo.

Figure 5: Asian Bonds Online: Steep Yield Curves

Mr. Guinigundo doesn’t seem to realize that local inflation will likely speed ahead of the US given the domestic market’s likelihood to respond better to low interest (see figure 6), the El Nino problem which will likely aggravate the looming shortages of our agricultural produce already hampered by last year’s Typhoon Ketsana nickname Ondoy and Typhoon Parma nickname Pepeng, and compounded by rising oil prices in the global market.

These factors, which weigh heavily on our local CPI, would likely pivot up the domestic interest rates ahead of the US, perhaps as soon as the local elections are concluded in May.

The basic flaw is to read Fed’s policies as oversimplistically linear, as the case is with most of the practicing aggregatists which tend to pick on select variables to highlight on their desired outcome.

We can’t entirely blame Mr. Guinigundo since as one of the leading technocrat for the banking sector, media publicity demands for “simplistic” replies.

By looking at the internal dynamics of the Phisix as potential measure of capital flows, the past two weeks has seen some substantial inflows from foreign funds. These inflows have been coincidental with the dramatic surge of the Phisix following the “Greek and China” myth induced meltdown during the prior weeks.

Yet compared to the 2003-2007 boom, where foreign funds constituted the bulk of the trades, today’s market attribute reveals the opposite local investors dominate trade.

But given the inflationist approach by major economies in dealing with their local predicament, it isn’t far fetched that the “widening” spreads [and “devaluing” foreign currencies] from which our domestic central bankers seems concerned of may come to fruition (see figure 6).

Figure 6: Money Week Asia [UBS]/ Wall Street Journal: Who Wins In A Liquidity Bubble/Private Capital Inflows

And considering the underdeveloped and relatively small state of the Philippine Stock Exchange, a larger than usual foreign inflow can virtually exaggerate returns that could turn the Phisix into a full blown bubble as it had during the 1987-1994 chart (left window).

Phisix 10,000? That should be peanuts compared to the returns then (the Philippines and Indonesia had nearly 1,000% gains while Thailand had 800%. Argentina and Mexico had even an astounding 1,400% gains-all in US dollar terms.)

It isn’t likely that past performance would exactly repeat, but as shown in the right window, foreign capital flows into emerging markets appear to be accelerating anew and they may contribute to enhanced returns based on global policy arbitrages.

And it is also why the IMF has reverted to its interventionist tendencies and has recently prescribed capital controls for emerging markets, ironically aimed at curtailing inflows. This is in sharp contrast to the past where it recommended capital controls to prevent outflows.

Times have indeed changed.

So while many seem to fear for a reprise of 2008, a dynamic which we see as a remote possibility since most of these fears appear to be predicated on Posttraumatic Stress Disorder (PTSD) [see What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?], we see that excess reserves and the inflationist proclivities of developed economies in dealing with their fiscal woes as risking a supersized global inflation or serial bubble blowing in Asia and or in emerging markets.

In short, while many fear a meltdown, I am concerned of a meltup.

Finally, if gold surpasses its resistance at 1,120-1,125, it is likely that global markets will continue moving against a wall of worry or continually move uphill. This ascent will especially be stronger if both the US and China’s markets chimes in.

Donald Coxe: Underweight US Markets, Overweight Commodities, Canada And Emerging Markets

Donald Coxe in his December issue of Basic Points has some interesting recommendations (hat tip: Prieur Du Plessis)

From Mr. Coxe: (bold and italics highlights mine)

1. Remain underweighted in US equities - as a percentage of equities within global portfolios, and as a percentage of assets in US balanced portfolios. Underweight US bonds in global portfolios.

The long-term financial projections for the US are scary, even if one accepts the Obama assumptions: ten years of large deficits, no recessions, strong, sustained economic growth, and a mere 1% increase in Treasury yields. Those numbers make no allowance for the costs of health care, which will be huge. Debilitating tax increases are inevitable, even if the global warming “cap and tax” legislation does not pass.

2. Within US equity portfolios, underweight US economy-related stocks and overweight stocks tied to foreign economies.

US stocks outperformed after Obama’s election, but that created what could be called erogenous risk for investors. As long as the KRE [Regional Bank Index] continues to underperform both the BKX [Philadelphia Bank Index] and S&P, risks of a double-dip economy remain.

3. Overweight Emerged Markets (such as China, Hong Kong, Brazil, India and Korea) within global and international equity portfolios.

These markets should no longer be discounted heavily because of assumed gaps between their accounting and American practices. The credibility gap has been narrowed significantly. The FASB’s capitulation to Congressional pressure on big banks’ balance sheets is a sign that Volcker-style virtue is outdated.

4. Remain overweight commodity stocks within balanced accounts and equity-only accounts.

Strong commodity-oriented companies are tied to global growth trends, led by the Asian powerhouses, which means they have less endogenous risk than companies tied to the US and Europe.

5. Emphasize gold stocks in commodity stock accounts.

Gold and other precious metals appear to have entered a period of above-average volatility, but the unprecedented creation of paper money and national debts means ownership of the metals and producers will tend to reduce endogenous risk in most portfolios. The stocks will tend to outperform bullion on the upside; the bullion will outperform on the downside.

6. Continue to overweight the agriculture stocks.

The best-performing commodity group in the past three months has been the agricultural stocks, led by the machinery and fertilizer stocks. Street analysts turned negative on these groups during the summer, when it looked as if US crop production would reach painful levels. Then the weather intervened. We remain of the view that the best of the agriculture stocks are among the best-quality core positions among all equities.

7. Maintain exposure to the energy stocks, but continue to emphasize oil producers and to de-emphasize natural gas producers.

Oil and natural gas are both in oversupply at the moment. The difference is that crude oil prices remain strong despite oversupply, as oil companies and speculators hoard oil in anticipation of stronger demand next year - and in fear of a new Mideast war. Shale gas may be too readily available to be good short-term news for either the profits or stock prices of oil and gas producers - but Exxon’s move on XTO Energy shows what having huge shale reserves can do for takeover values in politically-secure terrain.

8. Base metal stock prices are somewhat riskier than those of other commodity groups, but are worth holding.

The producers are dependent on China’s willingness to continue to buy more metal than it needs for current consumption.

9. Within balanced portfolios, emphasize long-duration, high-quality bonds at the expense of Cash. Canadian bonds should be used by foreign investors, where possible, as alternatives to Treasurys and US corporates.

Cash isn’t a true risk reducer, because it delivers no yield and cannot rise if there’s a new panic. If you must own something that pays you nothing, buy gold. In contrast, long-duration bonds are the best hedge against a renewed economic downturn.

10. Canada offers better government, better governance, a better currency, and a better stock market than the USA. Buy Canadian.

The flip side to this is a wise balance sheet policy for Canadian companies. Borrowing in American dollars makes sense for Canadian exporters and resource companies - and for some other Canadian industries. Take advantage of (1) Bernanke’s heroin injections into US debt markets, and (2) Canada’s new financial prestige to reduce your endogenous currency risk by bulking up your borrowing in greenbacks.

Read the rest of Mr. Donald Coxe's report here.

BMO Capital Markets Basic Points Dec 2009

Global Inflationism: It's Not All About Gold

Many have argued that gold is in a bubble.

Yet, given the bigger picture, gold's recent spike pales in comparison to other commodities.
According to Bespoke Invest, ``While gold is currently grabbing the headlines, it's actually up the least out of the seven major commodities that are in the black this year. As shown, Copper is up the most with a gain of 126.7%. Orange juice is up the second most with a gain of 83.3%, while oil, silver, and platinum are all up more than 50%. Coffee and gold are both up about 30%. Three commodities are down in price in 2009 -- wheat (-20.27%), corn (-17%), and natural gas (-11.6%)."

However while momentum appears to have fizzled out for gold, the other precious metals and energy commodities, according anew to Bespoke, ``the breakfast drink commodities -- coffee and orange juice -- are both in strong uptrends and are trading right at overbought territory at the moment." For us, while we expect commodities to generally benefit from the loss of purchasing power of paper money or rising inflation, the rate of advances are likely to be divergent.

However, if indeed the US dollar system is suffering from what we deem as the initial symptoms of "demonetization", precious metals are likely to be the prime beneficiaries or 'leaders', from which should spillover to the general commodities sphere.

As Ludwig von Mises explained,

``The divorce of a money, which is proving increasingly useless, from trade begins when it starts coming out of hoarding. If people want marketable goods available to meet unanticipated future needs, they start to accumulate other moneys, for instance, metallic (gold and silver) moneys, foreign notes, and occasionally also domestic notes which are valued more highly because their quantity cannot be increased by the government, such as the Romanov ruble of Russia or the "blue" money of Communist Hungary. Then too, for the same purpose, people begin to acquire metal bars, precious stones and pearls, even pictures, other art objects and postage stamps. An additional step in displacing a no-longer-useful money is the shift to making credit transactions in foreign currencies or metallic commodity money which, for all practical purposes, means only gold." (bold highlights mine)

Put differently, gold's rise while symptomatic of a monetary disorder hasn't reached the level where rampant demonetization is taking hold yet.

Albeit, the symptoms can hardly be ignored as seen from the chart above from goldmoney.com where gold is even outperforming against the Euro. To quote James Turk of gold money,

``When viewed against gold, the time-tested numéraire of all national currencies, we can see that the euro is collapsing almost as fast as the dollar, which is not too surprising. The dollar and the euro have both caught the fatal disease that inevitably inflicts and eventually kills all fiat currencies – central bank mismanagement."

The Lost Decade: US Edition

Mr. Floyd Norris of the New York Times gives us a good account of how US stocks have fared in a relative sense compared to emerging markets and commodities over the past decade or so...


According to Mr. Norris, (all bold highlight mine) ``THE American stock market has soared 64 percent since it hit bottom eight months ago.

``And that leaves it just where it was more than 11 years ago.

``The United States stock market was the world leader in the great bull market of the late 1990s, but more recently it has been a laggard, in large part because of the weakness of the dollar. As the accompanying charts show, a stock investor looking for a part of the world to invest in back in 1998 — and to hold onto until now — could not have done worse than to choose the United States.

``The charts show the movement of the Standard &Poor’s 500 and the S.& P. International 700 in the period since the American index first reached 1,100 on March 24, 1998. The International 700, which encompasses the non-American stocks in the S.& P. Global 1,200, rose much faster in the middle of this decade, then fell faster in the global recession. But since prices bottomed, it has leaped more than 80 percent.

``For the entire period, an investor was better off in emerging markets than in the developed world. The segments of the global index representing Latin America, Australia and emerging Asian countries have soared. The Canadian index also more than doubled, thanks largely to natural resources stocks.

``But prices, as measured in local currencies, are lower now than in 1998 for both the S.& P. Europe 350 and the S.& P./Topix 150, covering Japan. Measured in American dollars, as shown in the charts, those markets posted gains of 20 percent and 7 percent, respectively, because of currency movements.

``On a sector basis, the best place to be over that period, both in the United States and globally, was in energy stocks. Oil prices fell to just above $10 a barrel in late 1998, and few investors saw value in the area. More recently, oil company profits set records as crude soared well above $100 a barrel, and even after the global downturn the price is more than $70.

``Financial stocks have suffered more in the United States than in the rest of the world, but the credit crisis brought down many banks in other regions as well.

``The charts also show 15 well-known companies from around the globe whose share prices are at least 300 percent higher than they were in 1998, and 15 such companies whose prices are less than half what they were then."

Additional comments:

-the return of the S & P 500 to the 1,100 level established 11 years ago implies that the US stocks have been in a bear market. It resembles Japan's lost decade-the American Edition.

This means that investors have largely lost than profited from stock investment.

-losses in the US markets do not account for real or inflation adjusted returns. According to the inflation calculator of the Bls.gov the US dollar has lost 25% of its purchasing power since 1998.This implies that US stocks have yet to recoup the real inflation adjusted levels in spite of the S&P reclaiming the 1,100.

-commodities and emerging markets have been clear outstanding winners.


-the Dow Jones have essentially reflected on the inflation of the US dollar, which have lost 75% in relative terms against gold.

This essentially debunks objections that gold is a lousy investment because it has no income. Chart courtesy of Reuters

-the US dollar isn't the primary source of the 'stagnation' of US stocks but instead reflects on bubble policies imposed by the US government. The US dollar serves only as a market outlet or a manifestation of such imprudent policies.

-This also shows that bubble policies have temporary benefits and don't work or prolongs investor agony over the long run, yet government officials are addicted to them.

-In addition, this also implies that the current policy directives to devalue the US dollar aimed at propping up the banking system and to reduce real liabilities means a wealth transfer and further outperformance of commodities and emerging markets relative to the US.

Jim Rogers Versus Nouriel Roubini On Gold, Commodities And Emerging Market Bubble

The celebrity guru strikes again!

Mr. Nouriel Roubini, whose shot to fame and stardom came after accurately predicting last year's crisis and has been media's du jour favorite gloom spinmeister or otherwise known as "Dr. Doom", recently predicted that every assets, including commodities and emerging markets stocks are in a bubble!

Mr. Roubini's captivating 'one size fits all' theory for this forecast is based on the US dollar as the "mother" of all carry trade.

In a recent column at the Financial Times Mr. Roubini wrote, ``Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions."

Portraits from Bloomberg

Hence he predicts a massive recovery of the US dollar, as every asset class anchored to the carry trade collapses.

It would seem that the 2008 financial crash functions as Mr. Roubini's operating paragon from which this call has been predicated (Anchoring bias?).

Bloomberg recently interviewed commodity king Jim Rogers, who dismissed Mr. Roubini's prediction.

According to Bloomberg,

``Many commodities are still down from record highs and equity markets aren’t on the brink of collapse, Rogers, chairman of Singapore-based Rogers Holdings, said in an interview on Bloomberg Television today. The price of gold will double to at least $2,000 an ounce in the next decade, he said.

“What bubble?” Rogers said, when asked if he agreed with Roubini’s view. “It’s clear Mr. Roubini hasn’t done his homework, yet again.”

``Rogers countered Roubini’s arguments by saying that Chinese stocks and sugar, silver, coffee and cotton have all dropped from their historical highs by at least 50 percent.

A sample of commodities (sugar and cotton) cited by Mr. Rogers are far from their all highs, as seen from the chart above courtesy of Moore Research Center.

One must note that the above charts exhibits nominal and not inflation adjusted prices.

Again from Bloomberg, ``When asked if gains made this year pointed to a bubble, he said: “It’s not a bubble if something is up 100 percent this year, but down 70 percent from its high. That’s not a bubble, that’s a good year. That’s a great year. Maybe it’s too high for this year, but that’s not a bubble.”

``“I suspect it’s going to go over $2000 some time in the bull market, but depending on what happens in the world it could go much, much higher,” Rogers said. “The old high, back in 1980 adjusted for inflation, would be over $2000 now, just to get back to the old high. So we’ll certainly get there some time in the next decade.”

``“I don’t know any emerging market stock markets that are so high I’d call them a bubble,” Rogers said. “They’re certainly all up a lot, maybe they’re too high, but being too high is not a bubble for anyone who knows financial markets.”...

``In contrast to Roubini, Rogers said the only bubble he sees in the Western world now is in U.S. bonds."

You can watch the video of Jim Roger's interview here

Meanwhile Mr. Roubini countered Mr. Rogers' objection by saying that gold at $2,000 is "utter nonsense".

According to Bloomberg, ``There is no inflation or “near-depression” to drive gold prices that high, Roubini said today at the Inside Commodities Conference in New York. If a severe depression came to pass, with investors buying canned goods and hiding out in log cabins, “maybe you want some gold in that scenario,” Roubini said.

``“Maybe it will reach $1,100 or so but $1,500 or $2,000 is nonsense,” Roubini said. Gold rose to a record $1,098.50 today in New York on speculation that central banks and investors will purchase the metal to hedge against a declining dollar...

``“It is very hard to justify oil going from $30 to above $80 based only on the fundamentals of supply and demand,” Roubini said. Prices are “in part” a bubble, Roubini said.

``Roubini predicted in 2006 the financial crisis that spurred more than $1.6 trillion of credit losses and asset writedowns at global financial companies".

As you would note, media highlights on Mr. Roubini's favorable call but ignores his glitches and miscalls.

Earlier this year Mr. Roubini predicted stagdeflation, a continuing rout in asset markets including oil. According to Bloomberg (Jan 20th), ``Nouriel Roubini, the New York University professor who predicted last year’s economic and stock market meltdowns, said oil prices will trade between $30 and $40 a barrel this year.

“I see oil remaining throughout 2009 in the range of $30 to $40” a barrel, Roubini said in Dubai today."

In an earlier post we noted how Mr. Roubini hit only one out of several calls,see earlier post Wall St. Cheat Sheet: Nouriel Roubini Unmasked; Lessons, yet managed to harvest media's attention.

Going back to Mr. Roubini's theme of the US Dollar Carry. Here is why we are in the camp of Jim Rogers.

1. Past Performance don't guarantee future results.

Last year's carry trade paradigm had been based on financial institutions, such as the shadow banking system, and foreign banks (as Iceland and parts of Europe) which leveraged on the currency arbitrage.

Today, hardly the same parties or sector appear to be engaged in the said arbitrage activities considering their debilitated conditions.

Next, it isn't the carry trade that brought down the house in 2008, it was the US housing bubble. The carry trade only exacerbated on the downturn.

2. Barking At the Wrong Tree.

It isn't just private sector speculation as Mr. Roubini sees it, but governments' "speculating" as well.

The recent sale of half of IMF's gold stash to India (Bloomberg) came as surprise to the market whom expected China to do the bidding.

To add China has been engaged in a buying spree of commodity assets globally as seen by the World Bank table above.

In short, the governments of emerging markets have in themselves been "speculating".

Of course we'd like to add that these speculative activities isn't myopically based on "animal spirits", because there are underlying geopolitical and monetary dimensions in these.

3. US dollar carry isn't likely to be a major factor.

Given the massive deficits and the monetary inflation engaged by the US, it would be naive or blind allegiance on the side of professional investors to discard the risks of higher interest rates by taking large positions for such arbitrage.

4. Money is neutral.

Mainstream always view money as a seeming constant where additional inputs of money are deemed as not to have an impact on the supply and demand balances. This is evident on Mr. Roubini remarks "very hard to justify oil going from $30 to above $80 based only on the fundamentals of supply and demand"

Mr. Roubini underestimates the impact of the global reflation efforts by collective governments on global economies. Moreover, Mr. Roubini reflects on the mainstream view which have been moored upon the US as still the key engine of global growth.

Yet apparently Mr. Roubini sees today's higher commodity prices as having little impact on inflation, he says, there ``is no inflation or “near-depression” to drive gold prices that high"


On the other hand, Bespoke Invest sees inflation on the horizon, ``Over the last ten years, trends in the CS have often preceded moves in the CPI. So when the net reading in the CS rises, increases in the CPI are typically not far off. Therefore, given that the net number of commodities rising in price is currently at +10 from a low of -15 in February, don't be surprised if upcoming inflation reports come in on the high side of expectations."

5. Wrong Models/Apples And Oranges

Gold isn't likely to rise during a deflationary depression (a view which Mr. Roubini leans on).

To argue for gold's strength on a Great Depression paragon misses the point that the US dollar then operated under a quasi gold standard. Thereby the rush to the US dollar equaled the rush to gold. That would be comparing apples to oranges today.

Gold doesn't serve as a medium of exchange for the consuming public today, but is still used as reserves by central banks. So gold's strength will be magnified by an inflationary depression and not during deflation.

In contrast to Jim Rogers who says Mr Roubini hasn't done his homework, Mr. Roubini's call would seem like an attention generating act.

An oversimplified theme which connects to the prevailing bias, appeals to the public. Publicity matters more than the content.

Warren Buffett's Inflation Hedge: A Pick And Shovel Commodity Play In Burlington

Warren Buffett bets "all in" with a railroad company, Burlington Northern Santa Fe

This news excerpt from Bloomberg, (all bold highlights mine)

``Warren Buffett’sBerkshire Hathaway Inc. agreed to buy railroad Burlington Northern Santa Fe Corp. in what he described as an “all-in wager on the economic future of the United States.”

``The purchase, the largest ever for Berkshire, will cost the company $26 billion, or $100 a share in cash and stock, for the 77.4 percent of the railroad it doesn’t already own. Including his previous investment and debt assumption, the deal is valued at $44 billion, Omaha, Nebraska-based Berkshire said today in a statement...

``Berkshire has been building a stake in the Fort Worth, Texas-based railroad since 2006 as Buffett looked for what he called an “elephant”-sized acquisition allowing him to deploy his company’s cash hoard, which was more than $24 billion at the end of June. Trains stand to become more competitive against trucks with fuel prices high, he has said."

The rail business will comprise Berkshire's second largest risk exposure after insurance

From Bloomberg, ``Burlington Northern, with pretax income of $3.37 billion on revenue of $18 billion last year, would be Berkshire’s second- largest operating unit by sales. The McLane unit, which delivers food to grocery stores and restaurants by truck, earned $276 million on revenue of $29.9 billion in 2008."

``Berkshire’s largest business is insurance, with units including auto specialist Geico Corp. Buffett, who is the company’s chairman and chief executive officer, has said he likes insurance because he gets to invest the premiums paid by customers until the cash is needed to pay claims. The insurance businesses last year collectively earned $7.51 billion on revenue of $30.3 billion."

``Buffett will use $16 billion in cash for the deal, half of which is being borrowed from banks and will be paid back in three annual installments, he told the CNBC. Berkshire will have more than $20 billion in consolidated cash after the purchase, he said...

Buffett's applies Ben Graham's Margin of Safety via a wide investing moatthrough privileges derived from regulation (more evidence on Mr. Buffett as political entrepreneur see previous post Warren Buffett: From Value Investor To Political Entrepreneur?)...

Again from Bloomberg, ``Buffett is increasing his stake in an industry that doesn’t have any competitors for certain types of freight. Federal law requires some chemicals to be moved only by rail.

``Railroads burn less diesel fuel than trucks for each ton of cargo carried, giving companies such as Burlington Northern and Omaha-based Union Pacific a grip on bulk commodities such as coal. That fuel-efficiency advantage also gives railroads a share of the profits from moving goods such as Asian imports of cars and other consumer goods sent to U.S. West Coast ports.

``From ships, containers are loaded onto railcars to be hauled to so-called intermodal terminals, where they’re transferred to trucks for the final leg of their journey."

Finally, Warren Buffett's bet on the railroad industry seems like a pick-and-shovel (indirect) play on commodities or a massive bet on inflation.

According to wikipedia.org, ``Railroads carry a wide variety of commodities, coal being the most single important commodity. In 2006, coal accounted for 21 percent of rail revenue. Coal accounts around half of U.S. electricity generation. Other major commodities carried include chemicals, grain, non-metallic minerals, lumber, cars, and waste materials."

Burlington biggest carload is in coal (energy), which constitutes over 50% of the total and appear to compliment his MidAmerican Energy exposure while, chemicals and motor vehicles make up only 2% and 8%, respectively according to the company's site.

This means commodities with over 80% share of the company's freight cargo comprise is the main business for Burlington.

In other words, Mr. Buffett bets $44 billion on inflation. Action, indeed, speaks louder than words.

Graphic: World's Resources By Country

Mint.com provides a pleasant graphic on the distribution of the world's resources per country

Failed Correlation Trade Suggest China's Slump Could Be A Pause

Technically yes China's Shanghai index (SSEC) is in a bear market. Losses that reach 20% is technically defined as a bear market.

The SSEC could probably be haunted by the September-October seasonal stock market weakness.

In addition, many have used the Baltic Dry Index (BDI) as a "rational" for a major inflection point on China's stock market aside from the purported policy induced slowdown in credit flows.

Do we share the view that China's stocks will continue to collapse? No.

In contrast to the past where a decline in China's market had prompted for a rise in the US dollar index (for example see April) or our correlation trade, the recent slump have ironically been opposite-the US dollar Index fell!

Our correlation trade extrapolates to falling global stock markets and commodities along with a rising US dollar index (flight to safety) where a higher US dollar index would have signaled 'tightening liquidity'.

But this doesn't seem so. Hence the continued buoyancy in most stock markets.

The US stock markets ended lower last night but hardly reflected on SSEC's crash.

So if the US dollar index persist on weakening amidst sagging global markets, they are likely to signify an "interim pause" and not a major reason for a collapse.

And this should also apply to commodities.

As we see from the Russian experience, where the RTSI earlier fell by 30%, the Russian benchmark have managed to recover most of its loses and now trades above the 50-day moving averages.

This looks likely the paradigm for the SSEC than for a major meltdown.

Gold As Our Seasonal Barometer (For Stocks) II

Many analyst appear to be giving weight to the seasonality factors.

That's because the scars from the horrid events of 2008 remains freshly imprinted, as we pointed out in Gold As Our Seasonal Barometer

For instance this from US Global Investors,

`` Even as the markets are moving higher and excitement builds, don’t get too carried away. Late-summer trading volumes are notoriously low and this year is no exception. On top of that, money supply data from the Fed indicates negative growth over the past four weeks and the past quarter, which is historically a negative indicator for the equity markets.

``The graph shows the average monthly returns of the S&P 500 since 1970, September is by far the worst performing month of the year with average losses of about 1 percent."

Or this from Early To Rise,

``Research from Georgia Tech: Over a 200-year period, 15 out of 18 stock markets studied posted negative returns in September. From 1970 to 2007, all 18 posted negative returns.

``Consider these facts:

-The last bear market for U.S. stocks began in September of 2000.

-That market hit its lows in September of 2002.

-The Lehman Brothers collapse happened in September.

-The crash of 1987 happened in October, but the decline began in September.

-And the worst month of the great depression? September 1931, when the market fell 30 percent."

Or this new crash alert from an expert who rightly predicted last year's crash. This from Telegraph's Ambrose Evans Pritchard (bold highlights mine)

``After predicting a torrid "relief rally" over the early summer, Bob Janjuah at Royal Bank of Scotland is advising clients to take profits in global equity and commodity markets and prepare for another storm as winter nears.

"We are now in the middle of a parabolic spike up," he said in his latest confidential note to clients.

``"I expect this risk rally to continue into – and maybe through – a large part of August. What happens after that? The next ugly leg of the bear market begins as we get into the July through September 'tipping zone', driven by the failure of the data to validate the V (shaped recovery) that is now fully priced into markets."

``The key indicators to watch are business spending on equipment (Capex), incomes, jobs, and profits. Only a "surge higher" in these gauges can justify current asset prices. Results that are merely "less bad" will not suffice.

``He expects global stock markets to test their March lows, and probably worse. The slide could last three months. "A move to new lows is highly likely," he said."

For all we know they could all be right.

But as we earlier wrote, the fundamental forces behind 2008 and today have been substantially different.

We don't see today's rally as a dynamic emanating from "economic recovery" but from inflationary dynamics.

Second given the acknowledgment by global authorities of the continued fragility of today's economic environment, they are likely to keep the monetary spigot open.

All those issued money from thin air from global governments compounded by the growth in circulation credit arising from the low interest rates worldwide has to go somewhere.

And that somewhere has been in stocks, commodities and Asian/EM properties.

In addition, instead of using the seasonal performances of stocks as the yardstick for predicting a major bear market for turbulent September-October period, I would offer a shift in perspective- the US dollar index as the locus point of a possible major selloff in September-October.

Hence, I would prefer to benchmark gold's seasonal factors as barometer for the stock market. See my earlier explanation here.

Finally we can't discount sharp volatility given the inflationary landscape, but it doesn't mean stocks would crash ala 2008.

Mark Mobius: Expect Market Volatility, But Capitalize On The Opportunity

From Franklin Templeton's July Emerging Markets Review

Feature of the Month: Q&A on Emerging Markets with Mark Mobius, Executive Chairman, Templeton Asset Management Ltd. (red highlights mine)

Is the recent rally in emerging market equities sustainable?

Although we are optimistic about the markets’ upside potential, it is important to realize that volatility is still with us and will be with us for a while. This means that there will be down markets as well as up markets. We therefore must pay attention to valuations and long-term earnings growth prospects in order to avoid buying or holding expensive stocks as a result of dramatic price rises that we have seen. Current valuations are below the five-year high valuations and thus are not excessive.

Emerging market equity funds resumed net inflows, recording a record $26.5 billion of investment in the 2nd quarter. Do you think emerging markets will continue to attract inflows?

In general, we expect inflows to continue, however, there could also be some volatility. We cannot expect to see net inflows every month or every week, but in general the trend should be positive. In the first seven months of 2009, net inflows (using weekly data from www.emergingportfolio.com) totaled US$34.5 billion. This is more than 85% of the approximate US$40 billion in outflows in 2008.

What are the reasons?

A return of confidence in emerging markets, the desire for higher returns, an increase in investor risk appetite, the search for undervalued companies and most importantly, attractive valuations in emerging market companies drove the inflows.

Within the emerging markets universe, where do you see the most attractive opportunities at this juncture?

Since it’s usually possible to find at least a few bargains in most markets, all emerging market regions are looking exciting. Currently, our largest exposures are to Brazil, Russia, China, India and South Africa. In terms of sectors, commodity stocks also look good because some of them have declined significantly below their intrinsic worth and we expect the global demand for commodities to continue its long-term growth. Consumer stocks are also favored. With rising per capita income and strong demand for consumer and other goods, the earnings growth outlook for these stocks is positive.

The World Bank recently said that reduced capital inflows from exports, remittances and foreign direct investment means “increasingly grave economic prospects” for developing nations. Do you share the view and is it something to worry about?

The World Bank is normally "behind the curve" when it comes to economic projections. Economists tend to look through the rear view mirror and not ahead. While reduced capital inflows from exports, remittances and foreign direct investment could have a negative impact on emerging markets, we can expect to see increased inflows resulting from consumer and infrastructure spending growth compensate for this. This could allow markets to record positive economic growth. This is especially the case in markets such as China and India.

Are you still optimistic about Asia ex-Japan? Which markets are you most positive about?

Yes, Asia is the largest emerging market region in the world. Asian countries are also growing relatively fast. They include countries like China and India with very large populations whose per capita income is growing, and capital markets in those countries are undergoing rapid development. Economic growth remains relatively high, per capita incomes have been rising, valuations remain attractive and reforms continue, thus improving the region’s business and investment environment. Our largest exposures are to China, India, South Korea and Thailand.

What are your views on the BRICs bloc? Is it a good investment proposition?

Yes, we remain optimistic about the long-term future of the BRIC markets. The BRIC countries are among the fastest growing economies in the world. Moreover, foreign exchange reserves in all four countries remain high. The four markets together account for more than 40% of the world population. Domestic demand growth also remains robust. China and India continue to register significant positive GDP growth rates in spite of the global slowdown China continues to take great strides towards becoming a major global player. The Chinese economy is expected to grow about 8% in 2009 and its foreign reserves have surpassed US$2 trillion. Moreover, Brazil and Russia are resource rich countries and although commodity prices have declined from their peak, the longer trend for commodity prices is up and these countries will benefit from global demand for oil, steel, aluminum, pulp, and other commodities.

Commodity prices have rebounded strongly and this has augured well for emerging markets. What are your views on commodities going forward?

The outlook for commodities remains positive. Strong demand from emerging markets coupled a more inelastic supply could lead to higher prices in the future. In general, we expect commodity prices to maintain a long-term uptrend. However, this will not be without corrections along the way. A number of emerging markets are major suppliers of various commodities as well as big consumers. For example, Brazil is one of the world's largest suppliers of iron ore, Russia is the largest supplier of natural gas, and so forth. Also, since emerging markets have the most people in the world the potential demand for commodities in those countries is also great. It is no surprise therefore that interest in such commodities is important..

I'd like to add that Dr. Mobius recently reemphasized the volatility factor.

According to Bloomberg (bold highlights mine), “When you have these rapid increases, almost without correction, you will definitely have a correction at some point, so we can expect a lot of volatility,” Mobius, the executive chairman of Templeton Asset Management Ltd., said in an interview in Kuala Lumpur today. “Increases of 70 percent can be followed by decreases of 20 to 30 percent.”

The so-called correction “can happen anytime, probably this year,” Mobius said. “It may not be all at once, you may not see a decrease of 20 percent suddenly, it could be 10 percent here, and a rise of 5 percent then another 10 percent, you’ll see this kind of volatility in the markets.” He added that he was referring to shares “globally.”

Nonetheless he would use the correction to add positions...

Again from Bloomberg, ``The biggest risk for global stocks is the increase in initial share sales and bond issues, Mobius said today. Investors will be “selling to take up new stocks, that will impact the prices,” he said. Mobius, who oversees about $25 billion, on July 29 said he plans to double Templeton Asset Management’s emerging-market assets within two years."

Since he doesn't think its a bubble...

Again from Bloomberg, “I don’t think it’s a bubble” because “you don’t have the irrational exuberance so to speak that you would normally find in a bubble activity,” Mobius said. The government’s policies to rein in bank lending are a “good thing,” he said.

Our Mises Moment Answers Mainstream’s Conundrum of Market-Fundamental Disconnect

``But on the other hand inflation cannot continue indefinitely. As soon as the public realizes that the government does not intend to stop inflation, that the quantity of money will continue to increase with no end in sight, and that consequently the money prices of all goods and services will continue to soar with no possibility of stopping them, everybody will tend to buy as much as possible and to keep his ready cash at a minimum. The keeping of cash under such conditions involves not only the costs usually called interest, but also considerable losses due to the decrease in the money’s purchasing power. The advantages of holding cash must be bought at sacrifices which appear so high that everybody restricts more and more his ready cash. During the great inflations of World War I, this development was termed “a flight to commodities” and the “crack-up boom.” The monetary system is then bound to collapse; a panic ensues; it ends in a complete devaluation of money Barter is substituted or a new kind of money is resorted to. Examples are the Continental Currency in 1781, the French Assignats in 1796, and the German Mark in 1923.”-Ludwig von Mises, Interventionism: An Economic Analysis, Inflation and Credit Expansion

The mainstream is obviously very perplexed.

They can’t seem to figure what’s going on with market prices that can’t seem to match “fundamentals”.

Take this as an example. ``With oil inventories high and demand down year on year, yet prices surging, "fundamentalists" are puzzled” observes Liam Denning of the Wall street Journal.

Skeptical of the fundamental –market disconnect, the unconvinced Mr. Denning concludes his article with, `` Ultimately, however, the danger for China, and commodities bulls, is that Beijing's efforts fail to fully offset the harsh realities afflicting the world economy as a whole.” (bold highlight mine)

Figure 6: Wall Street Journal: China Watch The Body Language

Many have attributed the rise in oil or iron ore prices primarily to China see figure 6. But the unpleasant fact is that this isn’t just about oil or iron ore or China.

It’s about policy induced inflation whose growing influences are being ventilated on markets and which has been percolating and distorting the real economy.

And the primary mechanism for such release valve has been the US dollar.

As we wrote in last week’s Mainstream Denials And The Greenshoots of Inflation, a broadening category of the commodities have been experiencing price gains. So it’s not only oil or iron ore or gold but a whole range of commodities which includes food prices.

In addition, it isn’t just China or Sovereign Wealth Funds, but a broader spectrum of participants have joined the bandwagon as buyers of commodities. As we noted in Hedge Funds Pile Into Commodities, hedge funds have been growing exposure to commodities.

Even life insurance outfit as Northwestern Mutual Life Insurance Co. ``has bought gold for the first time the company’s 152-year history to hedge against further asset declines” (Bloomberg) could be signs of possible major reconfigurations of investments flows towards commodities.

My recent post which surprisingly turned out with a high number of hits, deals with Hedge Fund Ace John Paulson who made an amazing allotment of 46% of his portfolio into gold and gold related investments [see Hedge Fund Wizard John Paulson Loads Up On Gold]! He didn’t say why, but the message was loud and clear! What a statement.

Aside, Bond King and regulatory arbitrageur Bill Gross recently wrote to warn the public to diversify away from US dollar before ``central banks and sovereign wealth funds ultimately do the same amid concern about surging deficits” (Bloomberg)

He thinks that the US has reached a “point of no return”, again from the same Bloomberg article, ``“I think he’ll fail at pulling a balanced rabbit out of a hat,” Gross said from Pimco’s headquarters in Newport Beach, California. “They are talking about -- once the economy in the U.S. renormalizes -- the move back toward balance or much less of a deficit. I suspect that will be hard to do.”

Moreover, a public gold fever (not swine flu) appears to have infected ordinary Chinese sparked by the revelation of massive gold accumulations by the China’s government. According to the China Daily, ``Inspired by the increase in the government gold reserves, the more savvy investors are also buying shares of Chinese gold producers on the Shanghai Stock Exchange and the smaller Shenzhen Stock Exchange.”

Furthermore, drug trades have reportedly been reducing transactions based in the US dollar and could have possibly been replaced by trades in gold bullion (telegraph).

This Dollar based concerns won’t be complete without Russia’s continued outspoken campaign to replace the US dollar as the world’s international reserve currency, which apparently not only got support from major Emerging Markets as China and Brazil, but even the IMF has reportedly jumped on the bandwagon saying that replacing the US dollar is possible.

This from Bloomberg, ``The IMF’s so-called special drawing rights could be used as the basis for a new currency, First Deputy Managing Director John Lipsky told a panel discussing reserve currencies at the St. Petersburg International Economic Forum today.

``“There are many, many attractions in the long run to such an outcome,” Lipsky told a panel discussing reserve currencies at the St. Petersburg International Economic Forum today. “But this is not a quick, short or easy decision,” he said, adding that it would be “quite revolutionary.” (bold highlight mine)

And worst of all, US dollar as a safehaven status has been scoffed at by Chinese students! Incredible.

This from Reuters, ``"Chinese assets are very safe," Geithner said in response to a question after a speech at Peking University, where he studied Chinese as a student in the 1980s.

``His answer drew loud laughter from his student audience, reflecting skepticism in China about the wisdom of a developing country accumulating a vast stockpile of foreign reserves instead of spending the money to raise living standards at home.” (bold highlight mine)

It’s obviously a question of what degree of the Chinese population has been represented by the adverse reactions of Chinese students on Mr. Geithner’s statement. If these students account for a majority of China’s sentiment, then it is quite obvious that the public will likely be shunning the US dollar as mode of payment or as transactional currency or as medium of exchange (sooner than later) despite the Chinese policymakers’ avowed insistence to buy US dollar assets (but on a short term basis) which is no less than politically premised, as previously discussed here and here.

All these account for votes of displeasure over policies governing the US as reflected on its currency the US dollar, which mainstream can’t seem to comprehend.

As I wrote in my March outlook Expect A Different Inflationary Environment (emphasis added), ``This leads us to surmise that most of global stock markets (especially EM economies which we expect to rise faster in relative terms) could rise to absorb the collective inflationary actions led by the US Federal Reserve but on a much divergent scale. Currency destruction measures will also possibly support OECD prices but could underperform, as the onus from the tug-of-war will probably remain as a hefty drag in their financial markets.

``And this also suggests that commodity prices will also likely rise faster (although not equally in relative terms) than the previous experience which would eventually filter into consumer prices.

``In other words, the evolution of the opening up of about 3 billion people into the global markets, a more integrated global economy and the increased sophistication of the financial markets have successfully imbued the inflationary actions by central banks over the past few years. But this isn’t going to be the case this time around-unless economies which have low leverage level (mostly in the EM economies) will manage to sop up much of the slack.”

So far everything that we have said has turned out to be quite accurate.

But we seem to be transitioning to the next level.

This brings us to the question why the public seems to be gravitating towards commodities?

Ludwig von Mises has an explicit answer which I unearthed in Stabilization of the Monetary Unit? From the Viewpoint of Theory,

``If people are buying unnecessary commodities, or at least commodities not needed at the moment, because they do not want to hold on to their paper notes, then the process which forces the notes out of use as a generally acceptable medium of exchange has already begun. This is the beginning of the “demonetization” of the notes. The panicky quality inherent in the operation must speed up the process. It may be possible to calm the excited masses once, twice, perhaps even three or four times. However, matters must finally come to an end. Then there is no going back. Once the depreciation makes such rapid strides that sellers are fearful of suffering heavy losses, even if they buy again with the greatest possible speed, there is no longer any chance of rescuing the currency. In every country in which inflation has proceeded at a rapid pace, it has been discovered that the depreciation of the money has eventually proceeded faster than the increase in its quantity.”

So let us break these down into stages:

First, the loss of the currency’s purchasing power.

Second, is the loss of a currency’s function as medium of exchange or the “demonetization process”.

Third, is the accelerating feedback loop between the first two stages which brings upon the irreversibility of the process and

Finally, the total collapse of the currency.

So there you have it. The public’s increasing exposure to commodities is fundamentally a question of the viability of the present monetary standards.

So far the political path and market responses have been behaving exactly as described by Prof. von Mises.

Hence, I call this the Mises Moment.