China’s Attempt To Quash Its Homegrown Bubble

``Indeed, there are two potential scenarios for EM stock prices: either a full-fledged mania will develop with multiples continuing to expand, or, a setback/period of indigestion will occur before a new upleg develops. Currently, the odds of a mania-type pattern developing in emerging markets are not significant. If a mania were to develop, Chinese stocks would be at the epicenter because China has the fastest growth rate”-BCA Research, Emerging Markets Appear To Be Fully Priced

China seems bowing to international pressure.

Since she has been accused of fostering or blowing bubbles, where even popular fund manager James Chanos has openly declared shorting China which became a recent controversy in his debate with Jim Rogers [see Jim Chanos Goes From Micro To Macro With Bet Against China], over the past 3 weeks, China has responded by engaging in a series of implied tightening measures, i.e. by allowing T-Bill rates to increase, by raising bank reserves, and last week by verbally arm twisting her banks to curtail credit expansion. It’s almost like one intervention per week.

And when government intervenes in the marketplace we expect the impact in the direction of the planned intervention to manifest itself over the short term. And that’s the reason why China’s markets have underperformed the G-7 and its emerging market peers.

However, in my view, the argument over bubbles seems grossly misunderstood. A Bubble is essentially a cyclical process, where government interventions in the economy, primarily via interest rate manipulations and compounded by other regulations, lead to massive distortions in the patterns of production and capital allocation, which eventually results to relative overinvestments [as discussed in What’s The Yield Curve Saying About Asia And The Bubble Cycle?].

In short, such process is exhibited through phases. And one of the symptoms is that suppressed interest rates with the accompanying credit expansion make long term investments appealing.

And we seem to be getting anecdotal evidences from these;

From Edmund Harriss of Guinness Atkinson, ``Economic growth of near 10% in the past year has been fuelled by domestic growth, almost all in­vestment, on the back of huge injections of liquidity and increased debt. Over $1 trillion of new credit has been extended and while we can see that the bulk is intended for medium- and long-term investment rather than short-term there is no doubt that money has found its way into the stock and real-estate markets. The appearance of state companies at land auctions (those who have had no prior interest in buying land) is significant. This has contributed to soaring land prices and helped a recent land sale in Guangzhou to achieve a record price of $852 per square meter ($78 per square foot), some 54% above the offer price.”

From Robert J. Horrocks, PhD and Andrew Foster of Matthews Asia, ``Nevertheless, it is prudent to be cautious about bank lending—not because we fear an unmanageable amount of nonperforming loans for the economy, but because Chinese banks generally made 3-year loans for projects with decade-long payoff periods (i.e., loans that were not appropriately matched to cash flows). Banks may have lent on the assumption of local government backing, which ultimately may not be provided.”

The other symptom is that increased money supply fosters rising prices in the economic system which leads to pressures to raise interest rates (see figure 4)

Figure 4: Danske Bank: China’s Rising Inflation

As you can see, while China has indeed been exhibiting symptoms of a formative bubble, as manifested above via investments in long term projects, aside from sporadic signs of frothy prices and emergent inflation, there seems to be less convincing evidences yet [see China And The Bubble Cycle In Pictures] that she has transitioned into the culmination stage or the manic phase -where bubbles have reached its maximum point of elasticity which is usually in response to the rollback of easy money policies by the government.

Besides, manic phases usually don’t draw in many and vocal skeptics. Instead the public will most likely be talking of a NEW PARADIGM. In other words, a manic phase would translate to a capitulation of pessimists, cynics and skeptics.

Hence, credit expansion is a necessary but not a sufficient condition for a bubble ripe for implosion. The other necessary ingredients to complete the recipe would be an asset price melt-up (intensive overvaluations) backed by euphoric public (hallucinatory bullish sentiment).

In addition, China seems reluctant to directly raise interest rates.

That’s because we think that policy arbitrage could work to induce the aggravation of China’s bubble cycle despite her rigid capital regulatory regime. And so far these have been manifested by the waves of capital flows into her system-indirectly or via unregulated channels. (see figure 5)

Figure 5: Danske Bank: China’s Staggering Hot Money Flows

China’s reserve accumulation has been a product of direct and indirect foreign money flows into the system (left window) which is likewise manifested through record accumulation of reserves (right window).

According to Danske’ Flemming J. Nielsen, ``We see no signs that China’s reserve accumulation is easing in today’s data and it appears that speculative hot money inflows has become a major policy challenge for China. Firstly, Peoples Bank of China (PBoC) will be struggling to neutralize the liquidity impact from its massive purchase of foreign exchange. This might be one reason for PBoC raising its reserve requirement for banks earlier in the week. Secondly it underlines that despite China’s capital controls, capital flows has become more important and it has become more difficult for China to maintain an independent monetary policy, while simultaneously maintaining a quasi peg to USD.” (all bold highlights mine)

And it is also one reason why the Chinese government has utilized unorthodox means of curbing the credit process through “verbal persuasion” over her banking sector.

So yes, over the interim perhaps we should expect the Chinese government to constantly apply further pressure on its system in an attempt to wring out hot money and reduce credit expansion to avert a full blown bubble from developing. And this could equally translate to possible weakness in China’s stock markets over the interim, as the market adjusts to the conditions of repeated interventions of the Chinese government.

But no, if her asset markets begin to recover even amidst these attempts or if markets start to disregard such policies then watch out, the asset melt up phase could commence.

And as we earlier described in Asia And Emerging Markets Should Benefit From The 2010 Poker Bluff, the more China tightens via the interest rate tool, the bigger the odds for a melt up as the spread of interest rates between China and G-7 economies widens. This would emanate from policy divergences- a tightening China, while the US, UK, Japan and EU remain loose-which becomes the fodder to the next bubble in motion.

When Politics Ruled The Market: A Week Of Market Jitters

``The first lesson of economics is scarcity: There is never enough of anything to satisfy all those who want it. The first lesson of politics is to disregard the first lesson of economics.” Thomas Sowell

As we have repeatedly argued, politics today more than the economy shapes market activities. That’s because boom-bust cycles are essentially politically oriented where inflationism is about the politics of redistribution.

Whether the source of this week’s troubles has been from China, Greece or the US, they have a common denominator, politics rule the day.

Bizarrely, there has been an apparent disorientation from media on who to blame or which among these nations have spawned major global markets to swoon!

Perhaps we can get some clues from the recent activities depicted in the charts (see figure 1)

Figure 1: stockcharts.com: What Caused The Meltdown?

The Dow Jones Stoxx 50 (main window-STOX50) or a benchmark of major European heavyweights collapsed only during the last three successive sessions of the week which also had been reflected on the US S & P 500 ($SPX).

Whereas China’s Shanghai Index ($SSEC), has peaked last August of 2009 and has repeatedly been underpressure since the start of the year.

Meanwhile the US dollar index bottomed during the start of December, and has, from then substantially ascended.

So gleaned from the first mover advantage perhaps it could have been China. But correlations appear rather unconvincing. Possibly a time lag effect? Maybe.

Greek Mythology And Market Divergences

This brings us first to the Greece.

The Greek episode as we earlier discussed in Poker Bluffing Booby Traps: PIMCO And The PIIGS seems more like a political poker bluff. That’s because European authorities won’t likely afford to put at risk the Union’s credibility that could easily escalate and eventually result to its disintegration.

Moreover, it wouldn’t also seem in the interest of Greece to take radical actions that would result to its leaving the Union. Since most of her debts have been denominated in the Euro, any devaluation would only expand her outstanding liabilities and result to more painstaking adjustments.

The team from the Danske Bank, Frank Øland Hansen and Gustav Smidth, puts it nicely, ``Greece could also choose to leave the euro and devalue. This is seen as a 'quick-fix' by some market participants. The Greek Central Bank Governor, George Provopoulus, has however emphasised today in the Financial Times, that this is not an option. Referring to Greek mythology, he said that "The future of its economy is unwaveringly tied to the mast provided by the euro". If Greece were to leave the euro and devalue, the new currency would lack credibility and there would be expectations of further devaluations. The outcome would be higher inflation and higher rates. In addition, existing eurodenominated debt would become foreign-currency debt. Any devaluation of the new domestic currency against the euro would thus increase the debt burden. We think that this 'quick-fix' is a highly unlikely scenario too.”

In other words, Greece will have to embrace austerity with or without the Union. But to disengage with the Union will likely result to greater hardship (larger debt, lesser access to financing, lose the privilege of integrated markets) and could present as “lose-lose” scenario for both parties. Hence assuming reform under the EU’s auspices would likely result to enhanced collaborative efforts to resolve her problems.

So unless there would be other unidentified incentives that implicitly serve the political parties involved, the most likely option would possibly be either for a broad European based rescue or with an IMF assisted bailout for Greece.

Figure 2: Danske Bank: Credit Markets Amidst The Market Turmoil

True, while the recent market volatility has triggered considerable anxieties in the credit sphere, as premiums on Credit Default Swaps-or cost to insure bonds- have spiked, it’s been largely a Greek problem (see figure 2 left window-lime green trend line).

Although Italy (gray) and Spain (blue) have likewise accounted for substantial upside movements, it hasn’t been as steep as Greece.

On the other hand, Ireland’s CDS (red) has improved in spite of the recent trembler.

In addition, the index of high yield spreads of the European (right window-blue trend) and US corporations (red trend) appears somewhat little shaken by the turmoil.

Let me add that Greece’s equity bellwether, the Greece [Athens] General Share index, has fallen by 31% since mid October. This brings her back her down 61% off its 2007 highs which has been reflective of the market’s apprehensions over her default risks. The Greece index lost over 70% during the market meltdown of 2007-2008 on a peak-to-trough basis.

Now if the ECB’s forthcoming actions will, as we expect, likely focus on market calming measures then we should see some semblance of rebound for Europe’s market.

To give us a clue, former crisis affected economies of emerging Eastern Europe such as Estonia, Latvia, Lithuania, Ukraine appears to have even shrugged off the recent antsy to stage massive rallies. Estonia is up 30% (!!!) on a year to date or 3 weeks basis after falling by about 75% from the 2007 peak. The current rally has only recovered 50% of the losses [see Scorecard From This Week's Global Equity Bloodbath].

So unlike in the 2008 episode where there had been a generalized fear, which resulted to a flight to safety, the apparent market based dissonance gives some credence to the decoupling theory.

And this has two important implications:

One. If markets deteriorate further, then the current inter-market divergences (Euro credit spreads, emerging markets versus G-7 equities and bond performances) would appear as belated responses to the lead actions of the core group, particularly the G-7 and BRICs which recently suffered from heavy losses.

In short, the losses will spread and close any gap that would lead to a convergence-partially resembling the 2007-2008 episode. I say partially because policymakers given will likely react in the same magnitude and swiftness to arrest any signs of a repeat of a 2008-esque meltdown.

Two. If major markets do find some stabilization or a base in the coming sessions from the recent mayhem, then we should expect inter-market divergences to materially widen. This implies that major emerging markets will likely recover earlier or ahead of its developed country peers and that those that has recently outperformed as emerging Eastern Europe could increase its outperformances. Emerging Eastern Europe looks likely on a catch up mode.

So the perma bears, whom have mostly anchored on a 2008 meltdown or a Japan crash scenario, will possibly be met anew by another setback-failed predictions.

I think this is the most likely outcome given the significant evidences of market divergences (credit, equity and bond markets) in the face of this week’s intense selling pressure.

Gold Tracing Euro’s Path

Another aspect that I’d like to dispel is the nonsensical view that gold is behaving like a bursting bubble or reflecting on deflationary forces.

Figure 3: stockcharts.com: Nonsensical Views About Gold

One should realize that gold’s action has NOT been exhibiting deflation or inflation but instead has moved mainly in consonance with the Euro, or inversely, but to a lesser degree, against the US dollar index where the Euro constitutes a hefty 57.6% of the index (see figure 3).

Notice that the contours of both gold (candlestick) and the Euro ($xeu-black line behind gold) have been nearly the same for the past 6 months. Thereby any variances lie within the degree of the changes.

A rising Euro does NOT translate to “inflation” nor does a falling Euro imply “deflation”. That would be another sign of clustering illusions.

As the earlier divergences discussed, this seems UNLIKE the AFTER LEHMAN Syndrome of October 2008. It hasn’t been the case where liquidity is being sucked out of the system that has resulted to a banking gridlock. The problems such as Greece, China or the US Volker fund appear to be more political than economic.

In short, the Euro and gold has had a strong correlation of late. But as caveat, the high correlation doesn’t imply any semblance of causation, that’s because gold’s relevance is as nemesis of any paper based currency and that’s why even central bankers tacitly revere it as “insurance” [see Is Gold In A Bubble?].

More signs of divergences? Just look at copper ($copper). Even as gold and oil has flailed along with major equity benchmarks over the last few sessions, copper prices remains vibrant and even rose.

In addition, if one should argue about prices being representative of less speculation and more real demand for commodities, then the Baltic Dry Index seems to be another sign of deviation. It has been in consolidation.

In short, unless markets will prove us wrong, signs have been saying that the recent meltdown is likely a bear trap.

Analyzing Predictions

“I’ve been dealing with these big mathematical models of forecasting the economy…I’ve been in the forecasting business for 50 years…I’m no better than I ever was, and nobody else is. Forecasting 50 years ago was as good or as bad as it is today. And the reason is that human nature hasn’t changed. We can’t improve ourselves.” Alan Greenspan

Baseball legend Yogi Berra once quipped on a sarcastic irony on prediction, ``Prediction is very difficult, especially if it's about the future."

Nevertheless prediction has been hardwired into the mankind’s genes with the implicit goal to overcome risks in order to ensure existential continuity of the specie. As Peter Bernstein aptly wrote in Against The Gods, ``The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk…”

Predictions From A Historian’s Perspective

Well, prediction is a tricky business. Since the advancement of science, the scientific model (quantitative) approach has been frequently utilized to determine probabilistic outcomes given defined set of variables.

However, social science appear to be more complex than anticipated, given that people have different scale of values, which are likewise meaningfully influenced by the divergences in time preferences, and also influenced by sundry cognitive biases, which subsequently makes us respond differently even to the same set of conditions.

As mathematician and scientist Professor Benoit Mandelbrot of the Fractal Geometry fame said in a PBS News Hour Interview, ``The basis of weather forecasting is looking from the satellite and seeing the storm coming but not predicting that the storm will form, the behavior of economic phenomenon is far more complicated than the behavior of liquid and gasses” (underscore mine)

Since markets are essentially economic events, the complications is that they represent endemically a menagerie of action-reaction and stimulus-response feedback loop dynamics to which Professor Mandelbroit elucidated in The (Mis)Behaviour Of Markets as, ``prices are determined by endogenous effects peculiar to the inner workings of the markets themselves, rather than solely by the exogenous actions of outside events.”

So given that markets signify more of human action dynamics than the functional state of natural science then our choice in making predictions will be one similar to the work of historians. Murray N. Rothbard makes the appropriate analogy, ``The latter attempts to "predict" the events of the past by explaining their antecedent causes; similarly, the forecaster attempts to predict the events of the future on the basis of present and past events already known. He uses all his nomothetic knowledge, economic, political, military, psychological, and technological; but at best his work is an art rather than an exact science. Thus, some forecasters will inevitably be better than others, and the superior forecasters will make the more successful entrepreneurs, speculators, generals, and bettors on elections or football games.” (all bold underscore mine)

The point is: Markets are likely to exhibit the causal effects from precursory human actions than from math designed economic models that ignore the aspects of human decision making.

Unfortunately the mainstream appears addicted to apply models even if they’ve been proven to be repeatedly unrealistic, either for reputational (need to be seen as pedagogic) or for social affiliations (need to be seen talking the same language) motivations or due to ideological blindspots (dogmatic treatment of economic theories).

Predictions Based On Dumb Luck

Besides, predictions should be weighed from the angles of opportunity costs and the incentives of the forecaster’s standpoint.

When a forecast for a certain direction of the market is unfulfilled, but at worst, goes into substantially to the opposite direction, losses will be real for those who adhered to them.

For instance, many ‘experts’ who predicted the “crash of the stock market” in 2009, when the market soared anywhere from 20-50% based on G-7 and BRIC and key emerging markets, could have bled their customers dry or would have lost 20-50% in profit opportunities from such erroneous predictions.

Yet for them to bluster “I told you so!” because the markets sizably fell this week would signify as “even a broken clock is right twice a day”! This implies that they’ve been right for the wrong reasons or as indicated by Urban Dictionary “success obtained through dumb luck”.

Market predictions shouldn’t translate to an immediate or outright fulfillment but instead focus on mitigating risks and optimizing profits. When markets move violently against a touted position and the forecaster refuses to badge, then it isn’t about “mitigating risks and optimizing profits” nor is it about accuracy, but about being foolishly arrogant or about obstinately adhering to wrong analytical models.

Remember since markets move in only two directions (up or down)… they are going to be right somehow.

Nevertheless successful investing isn’t myopically about being theoretically right or wrong but about generating maximum profits from the right moves and reducing losses on the wrong moves.

Since as human beings we are susceptible to mundane lapses, then investing is about dealing with the magnitude or the scalability of the portfolio and not of the frequency of transactions. In addition, it is also about the allocative distribution of a portfolio pertinent to perceived risks conditions.

Furthermore, as we said in Reasons To Distrust Mainstream Economists, some forecasters have different incentives for making publicly based predictions.

Some are there for mere publicity purposes (celebrity guru such as Nouriel Roubini makes the spotlight anew with another wondrous shift by predicting a market meltdown in the 2^nd half! It’s amazing how media glorifies an expert whose calls have been repeatedly off tangent) or to promote certain agenda- e.g. promote political interventions-example Bill Gross [see Poker Bluffing Booby Traps: PIMCO And The PIIGS], sell newsletters, sell funds, etc...

For instance, some experts recently argued that the recent wobbles in Wall Street validates the state of the economy. Does this translate that markets only reflect on reality on when they conform to the directions advocated by these so-called “seers”? That would be utter crock.

The truth is that the current state of the global economy operates under a fiat money regime which perpetuate on the boom bust cycles, irrespective of the actions by regulators to curtail private greed but not on their actions-which have been the underlying cause of it.

Put bluntly, politically oriented boom bust cycles are the dominant and governing themes for both the global markets and the world economy. Therefore, market actions on both directions have been revealing these dynamics.

They don’t essentially validate or invalidate the workings of the economy, because they are `` endogenous effects peculiar to the inner workings of the markets themselves, rather than solely by the exogenous actions of outside events” as Professor Mandelbroit would argue.

Hence, the “desperately seeking normal” school of thought represents as a daft pursuit to resurrect old paradigms under UNSUPPORTIVE conditions- we don’t use radar to locate for submarines or any underwater objects!

Similarly ludicrous is to show comparative charts of the crash of 1929 as a seeming parallel for today’s prospective outcome. This is a brazen example of the cognitive bias known as the “clustering illusions” or seeking patterns where there is none.

Unfortunately, even professionals fall for such lunacy, which is emblematic of why mainstream analysis should be distrusted [see earlier discussion in Why Investor Irrationality Does Not Solely Account For Bubble Cycles].

These people fundamentally forget that 1920s operated on a GOLD STANDARD while today’s world has been on a de facto US dollar standard. Today we have deposit insurance when in 1929 crash we didn’t.

Today is the age of the internet or Web 2.0, where communications have advanced such that they are done by email, or conducted real time as voice mail, web based conferencing, digital cameras, iPods and etc., and where the cost to do business has substantially fallen to near zero and which has, consequently, attracted the scalability of globalization.

In the 1920s, communications were in a primal mode: stamped postal mails, the electrical telegraphs, manual based switchboard rotary telephones, and photography were based on celluloid film 35mm Leitz cameras. All these were emblematic that the 1920s had operated on an agro-industrial age.

Today we have niche or specialized markets when in the 1900s it was all about mass marketing. These are just a few of the major outstanding differences.

In short, the fact that the basic operating framework of the political economy has been disparate implies that the effects to the markets would be equally distinct. Think of it, fundamentally speaking, monetary policies in the pre Bretton Woods 1900s were restricted to the amount of gold held in a country’s reserves while today central banks have unrestrained capacity for currency issuance.

Columbia Business School’s Charles Calomiris makes this very important policy-market response feedback loop differentiation in an interview,

``From 1874 to 1913, there was a lot of globalization. But worldwide there were only 4 big banking crises…From 1978 to now, there have been 140 big banking crises, defined the same way as the earlier ones: total losses of banks in a country equalling or greater than 10% of GDP.” (bold highlights mine)

As you would notice, the emergence and proliferation of central banking coincided with the repeated and stressful occurrences of big banking crisis. Put differently, where central banking fiat currency replaced the gold the standard, banking crisis became a common feature. So to argue that market actions don’t reflect reality translates to a monumental incomprehension or misinterpretation of facts and theory.

Yet if markets should reflect on the same 1929 dynamics, this would be more the mechanics of dumb luck than representative of economic reality. Besides, to presuppose as engaging in “economic” analysis to support such outlandish theories, but without taking to account on these dissimilarities, would also signify as chimerical gibberish or pretentious knowledge.

Bottom line: I’d be careful about heeding on the predictions of the so-called experts, where I would read between the lines of interests of these forecasters, their way of interpreting facts and the theory used, aside from opportunity costs from lapses, and their forthrightness.

Yet, I’d pay heed to Benjamin Graham, the father of value investing when he admonished, ``If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market."

Scorecard From This Week's Global Equity Bloodbath

This chart from Bespoke presents a good coverage of this week's resurgent volatility. According to Bespoke,

``As shown, both the G-7 and BRIC countries sit at the top of the list of worst performers. The countries that have held up better are located mainly in the Middle East, Africa, and Eastern Europe.

``Combining the BRICs and the G-7, Russia has done the worst since Tuesday with a decline of 6.33%. But Brazil and the US are not far behind with declines of more than 5%. Italy, France, and Germany are all down around 4.75%, followed by Britain at -3.81%. There has been lots of talk about China partly at fault for the global sell-off, but the country itself is down just 3.64% since 1/19. Japan has by far done the best of the G-7 and BRIC countries over the last three days with a decline of just 1.62%."

While it is true that BRICs got equally hit as hard as the G-7, the picture isn't complete. In any comparison, points of references are important because they can tilt balance of presentation.

Remember, in 2009 the BRICs outperformed the G-7 by a wide wide wide margin hence it should be natural for them to bear the brunt of the recent carnage.

However, last week's selloff reveals that the damage hasn't been significantly different. And if the current correlation continue, one can expect the BRICs to materially outperform its G-7 counterparts anew.

Although as seen from a year to date (or on a 3-week) basis on the left column, the BRICs have marginally underperformed the G-7, however 3 weeks is too early to call.

Nevertheless the overall market conditions should give us some clues.

As mentioned by Bespoke some markets in former crisis plagued Eastern Europe and the Middle East have outperformed.

For instance, Estonia was up 7% on a week on week basis but is up 30% (!!!) on a year to date basis and so with her peers (also based on year to date) Latvia 15.04%, Lithuania 11.29%, Romania 7.2% and Ukraine 7.08 as well as Malta 13.27, Kenya 11.73%, Egypt 9.76% and so forth...

While everyone's focus (as indicated by Bespoke's article) has been on how the key markets got hammered (BRICs and G-7), what may have been ignored by the rest is how the broad periphery (emerging markets) had been vastly unfazed by the ruckus.

This for us, implies two significant messages:

First, that the periphery signifies delayed or belated reaction from the still to be felt ripples or

Second, that many emerging markets will likely show signs of meaningful divergences (decoupling), which could mark the theme for 2010.

And if it is the latter scenario, then this week's meltdown could be suggestive of a bear market trap.

Hazards Of Corporatism: The Bankruptcy of Japan Airlines

The unfortunate fate of Japan Airlines (JAL) should be a vivid demonstration of how companies that have been politically privileged, kept afloat and protected (zombie companies) despite continued financial losses, end up being malignantly mismanaged and eventually ran aground on a surfeit debt ($25 bilion).

This from the Wall Street Journal, (bold emphasis mine)

``Marking a fundamental shift to this nation's corporate culture, Japan AirlinesCorp. filed the country's largest-ever bankruptcy petition by a nonfinancial company, kicking off a painful, three-year restructuring that will have lasting effects on hundreds of thousands of people.

``Undone by government ties that propped up excessive spending, the former flag carrier now will significantly shrink its operations. A third of JAL's work force, 15,700 employees, will be axed. Thousands of retail shareholders will be wiped out. And bondholders will likely take a fat reduction to their holdings. Employees at JAL's sprawling group subsidiaries in Japan and abroad also will be affected...

``A pillar of Japan Inc. founded in 1951 to help the country rise from the ashes of World War II, Asia's largest airline by revenue sought court protection from creditors on Tuesday to grapple with a debt load of $25 billion, a level well above its cash flow.

``Much like Washington's takeover of General Motors Co., JAL will be aided by a $10 billion lifeline from its government through capital injections and credit and will spread billions of dollars in losses across an already weak Japanese economy. Bureaucrats strong-armed Japan's banks, the airline's biggest creditors, into forgiving more than $8 billion of JAL's debt. Retirees and employees accepted more than $11 billion in pension cuts, representing a 30% reduction for retirees and a 50% cut for current employees...

Kevin Duffy of Mises Blog aptly enumerates on the decade long sins of JAL which led to this...

From Mr. Duffy (all bold highlights mine),

``For the record, JAL offers a quick primer on how government intervention destroys an economy:

1. State ownership and control. "Though financial profligacy was one cause of JAL's demise, its close ties with the government -- even after it was privatized in 1987 -- effectively crippled the carrier. Pork-barrel aviation policies drawn up by transport bureaucrats caused JAL to fly unprofitable routes for decades."

2. Moral hazard of implicit government backing. The 1987 IPO (and others like it, such as Nippon Telephone & Telegraph) were wildly successful in part because investors felt the government wouldn't allow them to lose money.

3. Bubble behavior. "When Japan Inc. rose to glory in the late 1980s, gobbling up trophy icons such as New York's Rockefeller Center, JAL also spread its tentacles around the world by buying the Essex House in New York and setting up resorts in Hawaii."

4. Endless government lifelines. According to CNBC, JAL was bailed out four times by the Japanese government over the past decade".

For companies that had undergone the same 'bailout' process during this crisis, the JAL experience would seem as the most likely outcome, in the fullness of time.

Graphic: BRIC Versus G7

This is graphic is a comparative from the Financial Times between major emerging economies coined as the BRIC (Brazil, Russia, India and China) relative to G7 economies.

The chart highlights both the positive and the negative aspects of the BRICs.

Nonetheless I find this an apples and oranges comparison, therefore impertinent (which is why one should be cautious with the mainstream).

The advantage of the BRICs on the left corner is predicated on the projections of future performances: growth contributions, share of the economy and growth rate.

Whereas the right corner accounts for as the disadvantages of the BRICs which reflects on the present conditions (lower per capita GDP and weak private consumption).

The comparative graphic should have shown projections on similar time dimensions, unless the FT assumes that while BRIC outperforms in growth, per capita and private consumption remains static?!

Why Investor Irrationality Does Not Solely Account For Bubble Cycles

An academician recently suggested that the success of those who accurately identified and predicted the emergence and the impact of past bubbles had been a result of happenstance.

That's because allegedly, since it is human tendency to seek patterns even where there is none, which is known as clustering illusions, these patterns coincidentally played out favorably for those who made the seemingly prescient predictions.

The academic expert further claimed that bubbles signify as deviations from 'fundamentals'.

In other words, the bubble phenomenon has been largely blamed on irrational behavior or cognitive biases, in the perspective of the expert.

While we accede that cognitive biases have a major role to play in bubble cycles, we believe that irrational behavior is basically prompted by responses of the marketplace to the incentives shaped by displacements.

People just don't buy stocks or real estate out of mood or because today's horoscope column say so.

For whatever cognitive reasons for the transactional actions, they are facilitated by real forces such as easy access to credit, low interest rates and or other government policies that shape incentives such as subsidies, guarantees, distortive tax laws and etc...

Thus, while people can or will be herded into irrational behavior, such as impulsive buying, it takes money to drive up asset prices. And money functions like fuel that mobilizes a car-regardless of the intended destination of the driver [For all we know he can drive the vehicle off a cliff!].

And sound money based on real savings don't create nasty nationwide bubbles. That's because the ability to go on a speculative binge would be restricted or that the access to credit will be limited...in spite of one's irrationality.

On the other hand, credit expansion from money from thin air not only facilitate but magnifies such human frailty.

Besides, if bubbles are an outcome of people's irrationality and fundamentals are indeed the genuine basis to evaluate assets, then why is it that there has been no consensus or established formula on what defines as the winning fundamental metric for investing?

For instance, value investors differ from growth based investors. Moreover, even from the value standpoint, analysts have different approaches (e.g. Graham & Dodd and etc...). This would largely depend on the parameters (data points, reference points and disparate theories) used to interpret data and to arrive at value.

In short as with bubbles, the ambiguity of ascertaining the so-called scale of 'intrinsic' value of an asset largely depends on subjective appraisal.

This chart from Bespoke could be used as example.

The chart demonstrates the basic fundamental metric for analyzing global stocks. It shows of the Price Earning ratio PLUS GDP growth.
According to Bespoke (whose chart is shown above), ``In this regard, we have created "PEG" ratios for a number of countries using the P/E ratio of each country's main equity market index along with 2010 estimated GDP growth rates. Just as with stocks, the lower the country PEG, the more attractive. As shown, India has the best PEG out of the countries we analyzed. It has a P/E ratio of 26.19 and estimated 2010 GDP growth of 8%. While its P/E isn't as low as a lot of countries, its growth rate is very high. China ranks second with a PEG of 3.66. The US ranks in the middle of the pack with a P/E of 24.53 and estimated GDP growth of 2.6%. At the bottom of the list sits Switzerland, Italy, and the UK, while Australia, Japan, and Spain have negative PEGs due to either a negative P/E ratio or negative estimated GDP growth."

So in spite of the breathtaking 2009 run, the HIGH current PE ratios (left column) can be deflated by adding an input-GDP growth (mid column). For the others with low GDP the effects of overvaluation is apparently magnified. So an additional variable changes the entire assessment process.

Hence, as per the economic growth adjusted perspective, this would imply that many stocks markets from China down to Russia have yet ample room to climb (right column) without having to be labeled as bubble.

And conversely, nations with poor or relative lesser economic growth should underperform or become suspect to thriving bubbles (due to exorbitant PEG ratios), e.g. as Taiwan to UK, while those with negative PEGs as Australia, Japan and Spain would account for the worst!

I am not suggesting nor am I implying that this approach is the valid way to deal with the markets. In my view this would seem irrelevant, since policies have all been calibrated to bubble blowing dynamics.

My point is that people will anchor on anything that will reinforce their biases regardless of the instruments used.

From Asian Development Bank

And the story above will most likely change with additional inputs, such as expected inflation (see ADB chart), demographic trends, and etc.

Yet the more inputs, the less likely these models will reflect on the reality and the more likely these would reflect on the bias of the analyst.

Bottom line: If investor irrationality have allegedly been the primary factor to cause for bubble episodes, then in the same context, fundamental metrics are a function of cognitive dissonance from cognitive biases.

Investor irrationality aren't primarily the cause of bubble cycles. That's because markets reflect on the subjective appraisals of the incentive driven participants that are mostly likely shaped by government policies.

The Smoke And Mirror Game Of Politics: Pres. Obama's Proposed Bank Tax

This would seem like a good example of how politicians engage in the game of political "smoke and mirrors" to spruce up on their images.

Pres. Obama, who appears to be working to shore up his rapidly flagging approval ratings, recently took to task the banking industry and proposed that banks be levied to cover or redeem the cost of the spate of bailouts.

The New York Times quoted Pres. Obama who said that he wanted "to recover every single dime the American people are owed."

The articles continues with Pres. Obama's strident diatribe on these banks, ``“We’re already hearing a hue and cry from Wall Street suggesting that this proposed fee is not only unwelcome but unfair,” he said. “That by some twisted logic it is more appropriate for the American people to bear the cost of the bailout rather than the industry that benefited from it, even though these executives are out there giving themselves huge bonuses.”

``Mr. Obama continued, “What I say to these executives is this: Instead of sending a phalanx of lobbyists to fight this proposal or employing an army of lawyers and accountants to help evade the fee, I suggest you might want to consider simply meeting your responsibilities” — including by rolling back bonuses."

What else would seem as the most politically appealing way to pander to the uninformed public than to piggyback on the prevailing negative sentiment by taking on the lead role in bashing the sector!

However beyond the surface of the politically enticing rhetoric, there appears to be significant undertones.

Cumberland Advisors' Bob Eisenbeis scrutinized on the possible ways how such tax might be imposed and came up with this stirring conclusion.

From Mr. Eisenbeis (bold emphasis mine),

``Whether or not retribution is justified, the proposal from the Administration makes little economic sense. Moreover, the spin that the tax is intended to recoup the losses banks caused to the TARP is misleading, because the primary sources of those losses to date have been Freddie and Fannie and the automobile companies that may be exempted from the tax.

``If there is a desire to extract revenue-retribution from large institutions, it turns out that there is no easy way to do it. If one wants to punish management then the efforts should be directed towards taxing their bonuses and other compensation. But there are four problems with this. First, most of those responsible are no longer in their positions, so it will be the new management who will suffer, not those who caused the problems. Second, taxing bonuses won't prevent another crisis. Third, there are always ways around the tax, in terms of how payments can be structured. Finally, managers of foreign institutions that might be covered can escape entirely.

``If the objective is to levy the tax according to how government support was provided, there is the issue in the case of those TARP recipients that were "forced" to take the government support even though they didn't want it. It is not clear how one can rationalize imposing a penalty on those who took the funds to support the government's rescue policies, even if those policies were misguided. Furthermore, there is no justification from the taxpayers' perspective of excluding the auto companies or Freddie and Fannie from responsibilities for losses, as well."

Read the entire article here.

Aside from the above, which exposes that the said taxes will not exact the social retribution from which these have been meant for, the far more significant points emphasized by Mr. Eisenbeis is that big banks will likely skirt these taxes by employing tax avoidance schemes through the shifting of their "funding by booking liabilities off-shore" or by utilizing "off-balance-sheet mechanisms to duplicate the traditional loan-funding-by-liabilities process".

And the brunt of which will likely be borne by "institutions smaller then the top five or six, who are mainly the regional institutions whose main business is the lending and deposit taking upon which their profitability depends".

The other way to interpret this is that the interests of the big banks will likely remain unscathed or could even be protected, by having its competitive moats widen against aspiring rivals through such tax measures.

I understand this to be crony capitalism.

And those of the smaller units would likely serve as the political sacrificial lambs for Pres. Obama's approval seeking publicity stint.

Yet, the more important victim could be the customers of these smaller banking institutions or the small and mid scale enterprises which compose about half of the GDP and more than half of the employment of the US (wikipedia.org).

And what seems as a politically correct harangue may actually be of the reverse intent, another political poker bluff aimed to buttress select vested interests group/s.

Of course since the proposed taxes have NOT been finalized yet, all these would be speculation on our part.

The aim of this post is to show how these political manipulations happen even in the US which goes to show how susceptible countries like the Philippines is, given its highly fragile state of democracy (I would agree with Joe Studwell-it's more of manipulated democracy).

It’s Not Deleveraging But Inflationism, Stupid!

A popular analyst recently wrote in his weekly outlook that the underlying theme of today’s environment should be known as “It’s the Deleveraging, Stupid!”

Deleveraging is technically accurate if the argument is centered on the contracting credit activities of the private sector of the US economy.

But focusing on deleveraging isn’t correct, it’s misleading. That’s because the private sector isn’t the only part of the US economy.

On the contrary, since the crisis surfaced, US government’s share of the US economy has exploded.

From CFR.org

One must realize that even prior to the crisis that the trend of the US government’s contribution to the economy has already been expanding, albeit gradually.

The crisis only hastened the process.

From Business Insider

Well even in the labor market, government employment has now surpassed the private sector.

In short, it would be a terrible mistake to fixate on the private sector when government’s role in the economy has been capturing a fairly substantial share of the economic pie.

Laissez faire, anyone?

So is the US government also experiencing a "deleveraging"?

From Paul Kedrosky (March 2009)

Based on the overall credit picture of the US, the answer is clearly NO.

Total credit has surpassed 350% of the GDP of which the US Government’s leverage has virtually topped the private sector. And that was in 2008, at the height of the crisis! It should be more today.

Obviously, a bigger government translates to bigger spending.

From Heritage Foundation

This means that spending has to be financed by higher taxes, by borrowing or by printing money.

Since higher taxes won’t be politically appealing considering the frail state of the economy, then the palpable recourse is to borrow or let the printing press rip!

Yet speaking of government, until this point we have not seen signs of deleveraging.

From Heritage Foundation

But we are obviously seeing debt building up…leveraging by deficit spending and not deleveraging.

Of course, like many deflation proponents Japan’s lost decade has been made as a popular example of what the US outcome might be.

From McKinsey Global Institute

While everyone in the investing community seem to know that Japanese internal savings financed its debt burdens, what everyone don't seem to realize is that Japan’s policy priorities had been far different from the US.

Forget about Japan’s bubble bust as being “isolated”, the important difference is that Japan policies didn’t have to bother with much of the world.

The US, on the other hand, being the world’s primary foreign currency reserve, has had to deal not only with its own economy but importantly work to uphold its status as the world’s monopoly provider of the medium of exchange for international payment and settlement.

From Federal Reserve Bank of Atlanta

In short, the global banking system and its attendant liquidity required for most of its transactions, greatly depends on the US dollar (Federal Reserve), which has equally been dependent on its own banking system to facilitate this transmission.

Therefore, US authorities have had to face two competing priorities, particularly the banking system (its global seignorage status) or its economy.

They made a choice and it was to rescue the banking system-so it can provide liquidity to the world and retain the privilege of being the world's monetary hegemon.

Of course, US authorities has repeatedly justified that its banking system is a vital part of the US economy, if not THE economy.

And that’s the reason why the Fed lent, spent and guaranteed some $11.6 trillion (as of September 2009), to the sector.

This implies that resources had to be redirected to the banking system which have been drained from the real economy.

This massive act of redistribution epitomizes not deleveraging, but inflationism.

And as we said above, bigger spending requires financing from debt or the printing press, if taxes is the least available option.

But considering that its banking sector’s balance sheet had been stuffed with rubbish but labeled as 'AAA' assets during the days of delusion, a solution has to be made.

Hence Bernanke like a good student of the Great Depression resorted to what he deemed as the most effective strategy to deal with this problem. His solution is to use the magic wand, the nuclear or the Helicopter option.

So by the waving of his magic wand, this would now allow him to “hit two birds with a single stone”….

From the Federal Reserve of Cleveland

The quantitative easing program or what the Cleveland Fed euphemistically calls as the “Fed credit easing policy tools” is simply the printing press!

By buying assets of the banking system, the banks get a reprieve, aside from buying time to build up capital. By manipulating the mortgage and treasury markets (even possibly the stockmarkets) the banks earn from spreads. By pushing up asset prices the animal spirits are reanimated. People go out and borrow and spend again, hurray!

Central bankers once ridiculed Zimbabwe’s Dr. Gideon Gono but apparently his formula seem so chic these days, such that Dr. Gono must have felt exonerated.

So does this signify as “deleveraging”?

Again the answer is NO.

Credit Bubble Bulletin’s Doug Noland who recently dissected on the Federal Reserve’s 3^rd Quarter Flow of Funds has this to say, (bold emphasis mine)

``Once again, system Credit expansion was almost completely dominated by federal borrowings. For the quarter, federal government debt expanded at 20.6% annualized, down from Q2’s 28.2%, Q1’s 22.6%, and Q4 2008’s 37.0% SAAR. Domestic financial sector Credit contracted 9.3% SAAR, an improvement from Q2’s 12.5% contraction. Foreign sector U.S. borrowings expanded at a 14.9% rate, the strongest since Q1 2008….

``Over the past year, Treasury debt expanded $1.743 TN, or 30.2%, to $7.521 TN. Treasury borrowings were up $2.270 TN, or 43%, in just five quarters. And despite the contraction in overall mortgage borrowings, outstanding GSE MBS expanded $408bn, or 8.3%, over the past year to $5.30 TN. In the past eight quarters, GSE MBS expanded $1.057 TN, or 25%. For the quarter, GSE MBS expanded $481bn SAAR. In just five quarters, combined Treasury and GSE MBS expanded an unprecedented $2.810 TN. “Flow of funds” data continue to confirm the Government Finance Bubble thesis."

So yes, there is no quibble, the private sector has been deleveraging.

But NO, the government isn’t.

Instead what Doug Noland calls as “Government Finance Bubble thesis” alternatively means inflationism...again.

Bottom line: I hate to say this, but I’ll simply borrow or paraphrase the sarcasm imbued in the title used by the popular analyst, ``It’s not deleveraging, but inflationism, stupid!”