The Inflation Cycle Accelerates; Asia As Chief Beneficiary

``Neither China nor the US can morph into more balanced economies overnight, and China can't tolerate a sharp RMB appreciation to speed up the process. So the adjustment scenario will be disappointing, involving slower US demand and Chinese export growth. And higher US rates will be a vehicle to reinforce that outcome. In fact, the ‘impossible trinity' may be hitting Asia in reverse. An Asian rebound would normally induce capital inflows, rising asset values, a stronger currency and a tighter policy. But no one wants currency strength, and it is too soon to tighten. So, the authorities can and will intervene in FX markets and will probably tolerate too-loose liquidity and rising asset prices. As global investors seek higher returns outside US markets, the accompanying decline in risk-aversion probably won't be good, either for the dollar or for US Treasuries.”-Richard Berner, Morgan Stanley, Challenges to Rebalancing the US Economy

US dollar bulls and deflation advocates wildly gloated over China’s 7% collapse in its stock market but closed down 5% last Wednesday.

One even paraded the prediction made by a team of quants [as we earlier featured in China In A Bubble, ASEAN Next Leg Up?] as rationalization for such activities.

What was thought to be an important inflection point, eventually turned out to be a short term “tryst” as China’s stock market robustly recovered and nearly expunged the losses going into the last 2 sessions of the week.

And this was met with a deafening silence from the US dollar bulls.

Figure 2: Asianbondsonline: China’s yield curve remains steep

As we earlier said we won’t bet on the ridiculous notion that bubbles would pop so soon because, as we wrote from our earlier article, ``bubbles normally take time to reach a climax. For instance, the US real estate bubble ballooned from 2002-2006, while global stock markets inflated from 2003-2007. True, today’s China bubble could risk being pricked hastily or abruptly, but in my view, this may seem too early.”

``It’s because normal bubble cycles need sustained massive infusions (we seem to be seeing the first phase) and the vast concentrations or clustering of resource misallocations that could either become huge enough to be extremely sensitive to interest rate hikes or would require continued exponential amplification of credit to maintain present price levels or a pyramiding dynamics…until the structure in itself can’t be sustained (usually interest rates from market or policy induced does the trick).”

If we look at the China’s yield curve (see figure 2), the persistent steepness signifies as continued ultra loose monetary landscape thereby potentially posing as additional fuel for more stock market conflagration to the upside.

Although of course, since no trend goes in a straight line, the clashing combination of severely overbought conditions and price “stickiness” from the power of monetary policies could translate into sharp volatility.

But then again, the bubble cycles can stretch much further than anyone can expect them to. As mainstream’s most favorite icon, John Maynard Keynes used to say, “the markets can remain irrational far longer than you and I can remain solvent”.

Speculation Or Eroding Store Of Value?

China’s bubble isn’t confined to China.

Most emerging and Asian markets including the Philippine Phisix have now exhibited manifestations of bubble like circumstances.

Even the conditions of the US markets appear emit the same signals. Commodities are likewise manifesting bubble symptoms.

Yet all of these appear to be in response to the trajectory of the US dollar index, which as of Friday’s close appear to be at the verge of breaking both the critical support levels etched in December 2008 and June 2009, as shown last week.

The implication of a breakdown of the US dollar index is that it could further reaccelerate the “speculative” frenzy as “stickiness” from policy induced inflation appears to be accelerating.

The obverse perspective from that of speculation is the question of the state of paper money’s store of value.

Business Cycles and Speculative Errors

Curiously too, it would seem bizarre how policymakers have been drudging and debating over identifying and controlling bubbles, when bubbles are the direct and indirect consequences of their policies and seem to be popping all over like mushrooms in a field.

Haven’t you noticed, as global central banks simultaneously coordinated a zero rate bound approach with some apply quantitative “money printing” easing (QE) measures combined with massive fiscal stimulus programs, the apparent consequence has been rising stocks and commodities?

Of course, suggestions that today’s risks may pose as something like a ‘car accident’ operate from the perspective of randomness, where “animal spirits” which have gone berserk would suddenly stop for unexplained reasons.

For us, while random shocks may indeed occur, the significant part of such observation is the crucial misunderstanding of the speculative process of the policy induced business cycle.

As Jeremie T.A. Rostan fittingly explains,

``Speculative error can go on at no cost as long as that limit is not reached. In fact, there are two other limits. First, the rate of interest tends to rise to its real value, undermining the pseudoprofitability of the real assets underlying sensitive and risky assets. Thus, new credit has to be created constantly. Second, the injection of liquidity will have to be stopped at some point, or else hyperinflation will take place.”

Proof?

China has been warning its banks over the possibility of asset bubbles. And through fiat has directed ``banks to ensure unprecedented volumes of new loans are channelled into the real economy and not diverted into equity or real estate markets” reports the Financial Times.

When two banks reportedly responded to curb lending the result was Wednesday’s stock market crash.

This from Robert Flint of the Wall Street Journal (all bold highlights mine), ``On Tuesday, two of China's major lenders were quoted as saying they would sharply slow credit growth in the second half. This prompted fears of a sudden tightening of credit that could choke off the loans which have so far eased the effects of the world recession. Shanghai equity prices plunged as much as 7.7% at one point Wednesday and closed 5.0% down on the day.

``Later on Wednesday, the PBOC said it will emphasize market-based systems, rather than administrative controls, in guiding the appropriate growth of credit. PBOC Vice Governor Su Ning's comments appeared to signal the PBOC wasn't about to set loan curbs in the second half of this year to cool explosive lending growth, as it had done in 2008.

``Nevertheless, Mr. Su's comments were the most forceful yet from China's central bank in trying to talk down the lending spree put into motion by Beijing's massive stimulus program.”

So the Chinese government tried unsuccessfully to jawbone down the credit bacchanalia but the violent response from its credit addicted stock market, sent officials on an apparent U-turn.

Inflation Cycle and Price Controls

Has this been a surprise to us? The answer is NO.

We have been repeatedly saying all along that governments will persistently attempt to put a kibosh on the gamut of exploding surges of asset prices but the fear of recidivist recession or deflation will force them back into the same accommodative and expansionary stance.

That’s the legacy of government policy trends derived from the influences of central banking dogma.

And China’s official response has fallen precisely into the ambit of our expectations.

Moreover, policymakers are in a policy dilemma.

The appearance of short term gains from levitated asset prices has a reflexive feedback loop- it has successfully created the impression of an economic recovery, which subsequently has loosened up risk aversion thereby reducing demand for money but increasing the demand for holding assets.

Nevertheless these account for as footprints of inflation.

Policymakers are then on the hook to at least maintain present levels. Paradoxically, this requires even more credit creation.

As Ludwig von Mises wrote in Inflation and Price Controls (bold highlights mine),

``The problems the world must face today are those of runaway inflation. Such an inflation is always the outcome of a deliberate government policy. The government is on the one hand not prepared to restrict its expenditure. On the other hand it does not want to balance its budget by taxes levied or by loans from the public. It chooses inflation because it considers it as the minor evil. It goes on expanding credit and increasing the quantity of money in circulation because it does not see what the inevitable consequences of such a policy must be.”

And governments will attempt to conceal the adverse impact from their inflationary policies by diverting the public’s attention into scapegoating private enterprises and markets.

This extrapolates to the next measure-PRICE CONTROLS.

Again from Mr. von Mises from the same article, ``The real danger does not consist in what has happened already, but in the spurious doctrines from which these events have sprung. The superstition that it is possible for the government to eschew the inexorable consequences of inflation by price control is the main peril. For this doctrine diverts the public’s attention from the core of the problem. While the authorities are engaged in a useless fight against the attendant phenomena, only few people are attacking the source of the evil, the Treasury’s methods of providing for the enormous expenditures. While the bureaus make headlines with their activities, the statistical figures concerning the increase in the nation’s currency are relegated to an inconspicuous place in the newspapers’ financial pages.”

Evidence?

Each time oil prices went down during the last month they coincided with a barrage of fire from regulators whom have threatened to curb speculative trading (July 7, NYT) or impose additional regulations supposedly inspired from purported study that is due out soon, that pins the blame on speculators as “driving the wild swings in oil prices” (WSJ July 28)

Figure 3: Stockcharts.com: Oil Prices and Threats of Price controls

The blue arrows denotes of the dates where the threats of added scrutiny or imposition of price controls on oil trading had been broached.

Apparently, the efficacy of such government sponsored communication signals to rein the oil markets appears to be diminishing.

In addition, because of the fear of further reemergence of falling prices from short selling, new rules are being imposed (WSJ, July 28)

Since regulators such as David Altig, senior vice president and research director at the Atlanta Fed, concede that ``Markets are, everywhere and always, one step (or more) ahead of regulators”, this implies that stifling regulation will only cause market inefficiencies by the circumvention of the regulation by arbitraging on different but related markets or financial innovation.

To quote the WSJ, ``The [CME group] exchange's chief executive, Craig Donohue, said: "We are deeply concerned that inappropriate regulation of these markets will cause market participants to move to dark pools and other unregulated markets, causing irrevocable harm to the entire U.S. economy." Dark pools are private markets where large orders are transacted.” (bold highlight mine)

In effect, adamant denials of the culpability of government inflationary policies will only result to the aggravation of the problem and only heighten volatility risks.

Too bad regulators can’t seem to accept God’s natural laws of supply and demand as having more power than their bloated egos.

Asia: More Room For Bubble Blowing

Going back to Asia this very interesting chart from Nomura Securities (see figure 4). (HT: Fullermoney) appear to support the legs for a continued bubble blowing.

Figure 4: Nomura Securities: Asia & West At Opposite Poles

In Nomura’s Mixo Das and Paul Shulte chart, they project that Asia will likely outperform for the following reasons:

One. Low banking system leverage.

As per Nomura’s Mr. Das and Shulte, ``Asia has NO forced sale of assets, so it gets free reflation. Under-performance by Asia mutual/hedge funds, cash piles everywhere.”

Two. Deleveraging in bubble bust economies are likely to cause divergent flows in asset pricing trends with the East outperforming (aha! Decoupling is a myth!).

Three, Corporate tax increases in response to government programs to shore up national economies are likely to translate to higher relative shift in income that would benefit Asia and

Lastly, central bank balance sheets seem likely to favor Asia, as asset components are mainly on “safer” US treasuries compared to “toxic” or high risk assets for US or UK.

In short, yes, the bubble dynamics in Asia seem to have ample room to run based on sustained expansionary monetary policies coupled with conducive economic stories that should underpin the relative advantage of Asia vis-à-vis the West.

Rebalancing The Chinese Economy

Below is a video from the Economist on its macroeconomic perspective of the structural imbalances of the Chinese economy. Along with it, is its "simplified" prescription for resolving the predicament.

Pls click on the link below:

Nonetheless, here is an excellent counterbalanced perspective from Robert Blumen (all bold highlights mine),

``A mercantilist policy of subsidizing export industries does not make a country more prosperous. Economic growth can only mean an increase in the ability of an economic system to produce more consumption goods. In the global economy, the system is the entire world, with each nation contributing some portion of a single integrated capital structure. Producing a lot of capital goods - factories, shipping terminals, etc. -- does not necessarily contribute to economic growth if the physical stuff is not economic capital. Economic capital means that it is integrated into the global structure of production through economic calculation.

``The purpose of exporting is not to create more factories per se, nor is it to "create jobs". The purpose of production is for the producers, is to gain the ability to afford to purchase more goods -- either capital goods or consumption goods. Producing things at a loss consumes capital and makes the producer poorer.

``Nor is there such a thing as consumer-driven economic growth. Consumption is the result of economic growth -- savings and investment drives it. The idea that a country can "switch" from "export-driven growth" to "consumer-driven growth" ignores the specific and heterogeneous nature of capital. The fact that people are talking about this so much only indicates that a lot of the physical infrastructure in China is not economic capital. If the existing capital structure in China was to be used to create a different mix of goods - say low-end consumer goods for Chinese consumers with lower incomes than Western consumers -- then the values of these factories under economic calculation would be marked down considerably, in many cases below their costs."

Philippine Real Estate In 1st Quarter 2009, Down But Not Out

Philippine real estate prices declined (based on inflation adjusted prices), during the 1st quarter of the year.

That's according to globalpropertyguide.com, (all bold highlights mine)

``In early 2009, luxury condominium prices, and sales, both fell in Manila. Compared to the previous quarter, the average price of luxury three-bedroom condominiums in the Makati Central Business District dropped by 0.7%, according to Colliers International (a fall of 0.6% in real terms).

``During the year to Q1 2009 the average price has appeared to increase by 4.6%, to PHP101,000 per sq.m. But this increase is illusory, because when adjusted for inflation, the average price has in fact fallen by 2.2%.

``Two of the biggest real estate developers in the country, Ayala Land and Megaworld, experienced declining real estate sales in Q1 2009. Sales of residential projects of Ayala Land declined by 10%. Megaworld reported that a decline in its real estate sales was offset by rental income growth, and posted flat net earnings growth from the same period last year.

``Housing demand from US-based overseas Filipinos weakened significantly, due to the economic recession. This was slightly offset by demand from Overseas Filipinos Workers (OFWs) in the Middle East and Asia. But this may not last long, since most of these countries are in or near recession.

Nonetheless the study appears to rely heavily on remittances as the main driver for the domestic property market.

Again from Globalpropertyguide, ``There are approximately 9 million Overseas Filipinos (OF) worldwide, or around 10% of the Philippine population. Of all OFs, 42.3% are permanent.

``Among permanent OFs, 68.2% reside in the US, followed by Canada (11.1%), Europe (7.7%), Australia (6%), and Japan (3.6%). The economies of these countries are in deep recession.

``Saudi Arabia has the most OFWs, at 25.3% of the total, and followed by UAE (11.9%). Housing demand from OFWs in the Middle East is expected to weaken, because the economies of the major OFW employers, Saudi Arabia, UAE, and Kuwait, have weakened.

``Remittances from OFs are major drivers of consumption and investment in the Philippines. Remittances reached US$16.4 billion in 2008, around 9.7% of GDP. A significant portion of remittances is spent on housing.

``Although remittances grew 2.7% y-o-y to Q1 2009, total remittances in 2009 are expected only to match 2008 levels, in sharp contrast to double-digit growth rates in the past. In 2008, remittances rose 13.7%, following 13.2% growth in 2007, 19.4% in 2006 and 25% in 2005.

``Even if remittances continue growing in 2009, purchases of residential property may be delayed, until the economy recovers."

A view of the global recession from the Economist

Nonetheless, the study also reveals the other obstacles in the Philippine property market development.

Again from globalpropertyguide.com

``In the Philippines, most buyers pay in cash, or buy during the pre-sale period. With remittance-fed demand weakening, local demand is hampered by an underdeveloped mortgage system.

``The ratio of housing loans to GDP remains small, at less than 2%. Outstanding real estate loans for acquisition of residential property grew by an average of 14% annually from 2001 to 2007, to PHP112.2 (US$2.4) billion. Data for 2008 is still unavailable but growth is expected to exceed 10%, because the BSP relaxed rules on real estate lending in December 2007 to support the property industry.

``Despite this growth, several factors still hamper local mortgage market expansion. Banks impose restrictive lending conditions, and approval of loan applications takes a long time. Few major banks offer housing loans, and loans have similar terms and conditions. Land titling and registration problems are prevalent, as are delays in the foreclosure process.

``Housing loan rates charged by major commercial banks remain high, at around 9.5% for loans fixed for one year, and at least 11% for mortgages with rates fixed for five years or more. In-house financing offered by developers involves even higher rates of between 15% and 22%.

``The government-owned Pag-ibig Fund (Home Development Mutual Fund) offers lower interest rates of between 6% to 11.5%, depending on the amount borrowed and loan conditions. Compared to bank loans, the amount that can be borrowed is lower, but the payment periods are longer and loan-to-value ratios are higher. Membership requirements have to be fulfilled to get a loan.

But, the study suggest that yields from investment remain attractive

``In October 2008, the average rental yield for condominiums in CBDs in Metro Manila was around 9.4%, according to Global Property Guide research. The highest returns were achieved on condominiums measuring between 70 and 120 sq. m., with yields typically exceeding 10%. Rental yields are expected to remain high, as property prices are expected to fall faster than rents."

Here are my additional comments:

1. While I don't have the details of the entire property market, the stereotyped generalization of remittances driving consumption and investment (of the economy) and property prices seems vastly exaggerated.

As to how 10% of an economy is greater than the composite 90% of the economy is certainly beyond me. Up to now, I have yet to see figures (even estimates) from the so-called multiplier effects from remittances as a share of consumption or investments.

Also how much of property pricing dynamics are from remittances?

2. Property prices aren't the same. OFW's are likely to be buyers of low and middle cost housing than the luxury condo market. In short, different products for different markets.

3. There seems to be a much ignored factor-an inflationary environment that is symptomatic of the falling US dollar worldwide.

This suggests that for condominiums, aside from local residents or OFW remittance money, foreign money could pose as prospective buyers especially considering the attractive relative yield as mentioned above.

4. Ultra loose monetary policies here and abroad are likely to stimulate an asset chasing phenomenon. Aside from stocks, this should include the property sector.

Hence, buying from local residents, considering the immense liquidity in the domestic financial system, could boost property prices.

5. I don't share the view that property prices depends on economic recovery as to clear oversupply and push prices up. Inflationary monetary policies in a low leveraged environment could do the trick of inducing speculative money flows into property.

Here, economic recovery will lag property prices but will be subjected to the local boom bust cycle.

6. Lastly, some reasons why the development in the Philippine property sector has lagged the world has been addressed above: underdeveloped mortgage or capital market (which has led to few suppliers with tight standards and high rates) and stifling red tape.

Equity Premium: Product of Monetary Policy Interventions

In our previous article Why Stocks Could Outperform Bonds Over The Next Decade

However, Mr. Gerald Jackson of Brookesnews has an excellent theoretical dissertation underpinning this so called equity premium debate, (bold highlights mine)

we laid the case why I think stocks could outperform bonds (mostly from the inflation perspective)Let me quote Mr. Jackson,

``However, we live in the real world of uncertainty where markets exist because we do not have perfect foresight. Therefore the role of the market is to coordinate and distribute expectations and masses of incomplete knowledge to market participants who will then act according to their own expectations and experience. The world of uncertainty brings us to the nature of profit and its effect on shares. In a progressing economy — one that enjoys rising per capita investment — aggregate profits will always exceed aggregate losses."

``Obviously, if firms consistently make profits then the value of their shares must steadily rise. This means that equity returns must exceed the return on bonds. The reason is the nature of profit. Ludwig von Mises explained that profits are maladjustments between supply and demand. Hence factors become underpriced in relation to the value of their products whenever a genuine profit appears."

``Let us assume a general equilibrium position where all returns have been equalised. There would be no profits or losses and uncertainty would have disappeared. Let us now introduce uncertainty and losses but not profit into our model. Obviously a risk premium would now emerge. It should be equally obvious that the difference between the return on bonds and equities would be pure risk.

``The final step takes us into the real world of profits and losses where economic progress is the order of things. We would now find that the difference between bonds and equities has widened further because we now have to account for aggregate profits exceeding aggregate losses. Therefore profit equals any return over the rate of interest plus any attendant risk. In a progressing economy new ideas, inventions, techniques, innovations, etc, are being constantly applied through new capital combinations. This process constantly renders older capital combinations obsolete and leads to their dissolution thereby creating profitable opportunities."

In short, the fundamental difference between stocks and bond is profit. And by nature stocks, due to its claim on capital goods or earning streams, should outperform bonds.

But the so-called equity premium is the attendant volatility emanating from government policies from which Mr. Jackson defines as the ``gross monetary mismanagements distorts markets and inflates share prices. Sooner or later unavoidably painful corrections have to be made. When this happens the market gets the blame and calls are made on politicians to take action. This invariably results in highly damaging interventionist policies. All because basic truths about how shares are truly valued and how bad monetary policies cause financial crises have been forgotten."

Warren Buffett: Invest In Yourself, Stocks Over Cash

CNBC interviews Warren Buffett about a TV cartoon series which he stars in "The Secret Millionaire's club" and gets gobs of advise on inflation, stock investing and personal virtues.

Global Stock Market Performance Update: Proof of Rotational Effects and Tight Correlations

This is an example of how experts use specific time frames to prove a point.

This from Bespoke Invest,

(bold highlights mine)

``The S&P 500 is up 11.24% since July 10th, which is a significant move in such a short period of time. The recent gains also put the index up nicely at 8.28% year to date. As shown below, the US has performed well relative to the rest of the world. Since July 10th, it ranks 22nd out of 82 countries. Russia is up the most with a gain of 24.23%, followed by Hungary, Poland, Norway, Romania, and Germany. Middle and Eastern European countries have seen some of the biggest gains in recent weeks."

Adds Bespoke, ``While China has been the second best performing country (behind Peru) year to date, it is only up 10.32% since July 10th. This is better than most countries, but it hasn't been the worldwide leader that it was earlier in the year. Five of the G-7 countries have outperformed China, and all seven G-7 countries are in the top 50% in terms of performance. This is a sign that developed markets have been holding their own against emerging markets in recent weeks. Only ten out of 82 countries are down since July 10th, with Slovakia leading the way at -5.67%."

We are grateful to Bespoke for their wonderful graphics.

However, with China's year to date gains at a mindboggling 88.66% and with the Shanghai benchmark at grossly overbought conditions, it would be a puzzle or an irony to expect a continuation of such torrid pace of advances or even make a worthwhile comparison. 88% versus 9% (year-to-date) is just a wide wide chasm.

As we earlier wrote in Global Stock Market Performance Update: Rotational Effects and Tight Correlations

``If global markets have been driven by liquidity or monetary forces or inflation dynamics then it is quite obvious that there will be rotational effects and secondly, for the early movers some tight correlation, as global liquidity transmission interlinks divergent markets."

Hence, our views seem to get validated where we appear to be indeed witnessing rotational effects from inflationary policies as the market leadership has temporarily switched from (leaders) emerging markets to the (laggards) developing markets.

Another, as Bespoke likewise observed, only 10 out of 82 since July 10th are down, or 17 out of 82 global benchmarks on a year-to-date basis-signifies further proof of the "global liquidity transmission interlinks divergent markets", we earlier posited. Market gains seem to broadening on a worldwide basis, but not all.

Russia's RTS outperformance appear to be a function of a typical bullmarket trend.

As we commented in the same article, ``Russia's hefty decline exhibits overheating. The Russian benchmark is still the 5th best year to date performer IN SPITE of the recent (21%) downturn. It trails Peru, Sri Lanka, China and India."

Indeed, after a 50% fibonacci retracement since the March lows, Russia has used its recent reprieve and the opportune windows provide by developed markets as fulcrum to stage another gala rendition (even at the face of a mighty performance by developed economies.)

Bottom line: ``developed markets have been holding their own against emerging markets" because of the rotational effects and global liquidity transmission of the global inflation dynamics more than representative of idiosyncratic strength or traits.

At the end of the day, emerging markets has still patently outperformed its developed counterparts under present "ultra loose monetary" conditions.

Mises University: The Life And Work Of Ludwig Von Mises

From the Mises University, the life and work of Ludwig von Mises by Guido Hulsmann.

Learn the basics of the Austrian economics. (Source Mises Blog)

Asia Sows The Seeds Of The Business Cycle

``All of us are ignorant of most of what there is to know." Professor Richard Dawkins, British Ethologist, Evolutionary Biologist, and popular science author

Anybody arguing that stock markets are strictly determined by traditional fundamental metrics should look at the current earnings environment of the US S&P 500 in figure 1.

Figure 1: chartoftheday.com: Annual S&P 500 Earnings Collapsed!

As you would notice, the inflation adjusted earnings has essentially fallen off the cliff.

According to chartoftheday.com, the ``chart illustrates how earnings are expected (38% of S&P 500 companies have reported for Q2 2009) to have declined over 98% since peaking in Q3 2007, making this by far the largest decline on record (the data goes back to 1936). In fact, real earnings have dropped to a record low and if current estimates hold, Q3 2009 will see the first 12-month period during which S&P 500 earnings are negative.” (bold highlights mine)

Yet, with the S&P 500 up 11% over the last two weeks (+8.4% year to date and 43.8% since the March trough), many would probably impute a sharp earnings recovery for S&P component companies, and with it the US economy.

But such rationalization overlooks the obvious.

One, the S&P valuations appear to be priced for perfection.

And most importantly, as discussed in “Should We Follow Wall Street?” and “Worth Doing: Inflation Analytics Over Traditional Fundamentalism!”, stock market prices are increasingly being driven by inflation!

So any analysis which ignores the deepening significance of the inflation component in financial asset pricing would seem like ‘looking at the sun and calling it the moon’.

As Dr. Marc Faber aptly commented in a recent CNBC interview, ``The worst the economy becomes the more governments will print money and people will say, "well, the output gap will prevent inflation from occurring" Do you know what the output gap is in Zimbabwe? 99% below potential GDP and there you have the highest inflation."

This means that as global governments continue to maintain loose monetary policies, which encourages a speculative environment to revive the so-called “animal spirits”, and at the same time undertake expansion in fiscal spending, financial asset prices are most likely to exhibit dynamics which increasingly disconnects with economic and micro-fundamentals or where financial asset prices will detach from popular mainstream economic theories.

And distortions from government policies have always been vented in the currency (see Figure 2) and transmitted to various asset classes.

Figure 2: stockcharts.com: US Dollar Index At Cusp Of A Breakdown

As the US dollar index sags to the point of testing the massive “descending triangle” support level, global stocks (DJW) and commodities (CRB) have been benefiting from the ongoing risk realignment-where money has apparently been shifting away from the US dollar and US sovereigns.

The yields from 10 year US Treasury Notes (TNX) has been rising to reflect on a transition from a deflationary scare and a deep recession to what mainstream deems as “transition to moderate economic recovery”.

However to my mind, the confluence of price signals in the above markets seems increasingly a manifestation of the inflation genie becoming unshackled from the proverbial oil lamp.

With the prospective breakdown of the US dollar trade weighted index, we are likely to witness the acceleration of such inflationary bias.

In his Credit Bubble Bulletin, Doug Noland says it best (bold emphasis mine),

``The problem only seems to get clearer. The maladjusted US Bubble economy is sustained by $2.0 to $2.5 Trillion of new Credit – Credit that must largely be issued or guaranteed in Washington. This reflation (a.k.a. Credit inflation/currency devaluation) drives massive flows to China, Asia and the emerging markets that have few takers other than the central banks. And as economies recover and inflationary distortions reemerge, these enormous dollar flows can be expected to foment increasing policymaker angst. Asian reflation is poised to take on a wild life of its own, forcing policymakers at some point to confront today’s reality that dollar flows are destabilizing and unmanageable. China, in particular, faces tough choices when it comes both to managing its Bubble and accumulating massive quantities of IOUs of deteriorating quality.”

More Evidences Of China’s Bubble Conditions

Indeed, China’s “run away train” markets has significantly been exuding evidences of bubble like conditions [as previously discussed in China In A Bubble, ASEAN Next Leg Up?] see Figure 3, which should pose as a dilemma for policymakers.

Figure 3: US Global Funds: Hot Money Flows And Property Bubble

``The specter of hot money may have re-entered China. An increasing portion of China’s foreign reserve accumulation in recent months cannot be explained merely by trade inflows and foreign direct investment,” observes the US Global Investors, “betting on a strengthening Chinese currency, hot money from overseas added to the excess liquidity problem in China several years ago, and might be used again as another excuse for policy tightening in the future”

Meanwhile, the apparent euphoric mood has enchanted and drawn retail investors into the frenzied punting activities in their domestic stock market, according to Bloomberg, ``Individual investors opened 484,799 stock accounts last week, data from the nation’s clearing house showed today, the most since the five days ended Jan. 25, 2008, and almost five times this year’s low in January.”

And with a savings rate of 49.5% in 2007, according to the PBOC, (WSJ) the shifting of a substantial part of savings into the stockmarket could indeed power up a gargantuan bubble.

Hence, the transmission mechanism from US Federal Reserve inflationary monetary policies seems evident from the standpoint of momentum based international money flows which has bidded up both the stock market and the property market, while domestic policies in China have aggravated the national inflation dynamics.

And this hasn’t been limited to a China only affair.

We appear to be witnessing the same dynamics at work in Asia. As anticipated, Asia’s benchmark bourses saw a mighty succession of breakouts last week from their resistance levels in Hong Kong, South Korea, Australia, New Zealand, Sri Lanka, Indonesia, Singapore, Malaysia and the Philippines.

Meanwhile, Taiwan, Pakistan, Thailand and India are likewise drifting at resistance levels gearing up for the same upside thrust.

A Bank Financed Regional Bubble?

We have argued that low systemic private sector leverage, as represented by the corporate and household sectors, fused with high savings are likely to respond materially to national monetary policies (See figure 4).

Figure 4: ADB Economic Outlook: Asia’s Policy Rates and Bank Lending Growth

The point of our interest in the ADB chart, is that except for Taiwan and Hong Kong which saw a growth contraction in bank lending (upper left window), most of Asia, namely Singapore, Korea, and the ASEAN-4 which includes the Philippines, only saw a moderation- even in the face of the crisis.

Notice too that when ASEAN-4 policy rates had been cut from its peak in 2006 (bottom right window), bank lending growth on a year to year basis zoomed up in 2007 until it crested (upper right window) during the September 2008 Lehman bankruptcy.

Nonetheless, with artificially depressed policy rates as a function of the adaptation of myopic mainstream economics, which had been intended to spruce up consumption or the so called “aggregate demand”, bank lending growth seems poised for an explosive takeoff.

Figure 5: ADB: Importance of The Bank System In Asia

Unfortunately instead of sound investments which should translate to real economic growth, the public’s search for yield will redirect resources mostly to needless speculation.

And since bank lending has been the main credit intermediary for ASEAN (see Figure 5) or even for most of Asia’s economies we are going to possibly see a bank financed regional stock market bubble - where a big portion of the bank lending could be diverted into the stock market in an effort to extract marginal yield.

The Boom-Bust Business Cycle

And so the policy shaped investing landscape had been engineered to lure away the public from savings and into speculation and punting.

Essentially, the seed of business cycles has likewise been sown in Asia as the result of the aversion by global policymakers to face the consequences from previous policy errors.

As Professor Shawn Ritenour rightly argues in When Stimulus Does Not Stimulate (bold highlights mine),

``Artificial credit expansion — credit not funded by savings — creates the business cycle by spawning capital malinvestment. Artificial credit expansion makes many unwise investments (say, in residential and commercial real estate and financial derivatives) look profitable because of the accessibility of cheap credit, so business activity expands, manifesting itself in an inflationary boom. Bad investments, however, are not made economically sound merely because there is more money in existence. These bad investments eventually must be liquidated. The boom resolves itself in a bust whose twin children are capital consumption and unemployment. The moral of the story is that monetary inflation is not a way to sustainably generate economic prosperity.

``One thing the government does do, however, by increasing the money supply is discourage saving. This is because, as prices rise, money saved becomes worth less and less, so people are more likely to spend it on present consumption while the spending is good. Promoting consumption is the last thing we need to build up a capital stock that has been woefully depleted thanks to malinvestment. The old economic saw cuts true: there is no such thing as a free lunch, and there is no costless way to fund government spending.”

Policies that serially blows bubbles have never been sound or productive or generate sustained wealth. Moreover it serves to benefit a privileged few at the expense of the rest of the society.

Nevertheless, in an era of central banking, a policy engendered boom bust cycle is a hallmark feature that must be understood by any serious investors.

This is especially important considering the rapidly expanding role of inflation in financial asset pricing.

And Asian governments are likely to maintain present policies until the financial asset boom permeates to the real economy. From here, this would be interpreted by policymakers as having triumphantly reduced the risks of economic growth recession by reigniting economic growth through artificial credit expansion.

Sadly any perceived growth will be temporary, from where another crisis will emerge in the next few years ahead (2012 or 2013?).

For the interim, Asia’s stockmarket, under the guidance of policy induced incentives, seems likely to power up ahead.

Emotional Intelligence Tops Fundamentalism

``A good trader has to have three things: a chronic inability to accept things at face value, to feel continuously unsettled, and to have humility.” -Michael Steinhardt, American investor and Philanthropist

If there are any traits that need to be emulated from Wall Street savants are the ability to think objectively and independently, to engage in process analytics and most importantly to refrain from indulging in cognitive bias traps.

As Warren Buffett once observed, ``A great IQ is not needed to do well as an investor, what is needed is the ability to detach yourself from the crowd.”

Esteemed Trader and prolific newsletter writer Dennis Gartman also has the same insight in his 22 trading rules, ``An understanding of mass psychology is often more important than an understanding of economics. Markets are driven by human beings making human errors and also making super-human insights.”

This simply means instituting successful market positions requires the discipline of Emotional Intelligence (EI) over the façade of knowledge.

That’s because investors of all discipline essentially never get the markets always right.

And if the objective is to maximize profits and minimize losses, then damage control extrapolates to admitting wrong decisions which subsequently mean accepting the emotional angst of financial losses.

And that’s where emotional intelligence counts more than economics or financial analysis.

And that’s where most of Wall Street didn’t get it right during the recent meltdown.

Organizational behavior Professor Philip Tetlock in an interview at CNN Money expounds (underscore mine),

``But hubris may have played a bigger one. Remember Greek tragedy? The gods don't like mortals who get too uppity. In this case the biggest source of hubris was the mathematical models that claimed you could turn iffy loans into investment-grade securities. The models rested on a misplaced faith in the law of large numbers and on wildly miscalculated estimates of the likelihood of a national collapse in real estate. But mathematics has a certain mystique. People get intimidated by it, and no one challenged the models.” (Hat Tip: Gully)

So yes, hubris founded on the context of pretentious “technical” knowledge has immensely exposed the vulnerability Wall Street from which many has suffered from the recent collapse.

After all, success in investing would all be about the probabilities in terms instituting discipline over trading positions. As the legendary Peter Lynch once said, ``Six out of ten is all it takes to produce an enviable record on Wall Street.”

Why Stocks Could Outperform Bonds Over The Next Decade

``The investment world has gone from underpricing risk to overpricing it. Cash is earning close to nothing and will surely find its purchasing power eroded over time. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary."-Warren Buffett, annual letter to Berkshire shareholders

Despite the surfeit of available information via cyberspace, much of these do not necessarily account for as knowledge, since pieces of information could be irrelevant or just plain rubbish or built around flawed presumptions.

In last week’s Should We Follow Wall Street?, we disputed the idea of a universally accepted technical wisdom from Wall Street.

We made as one of our example the polemics about the equity premium or the comparison of the returns of bonds versus stocks.

Nitpicking over hundreds of years of data, for us, would seem like another exercise of vanity.

Unless humanity will reach a state of human-machine convergence or Singularity soon, from which futurist Ray Kurzweil predicts that ``our intelligence will become increasingly nonbiological and trillions of times more powerful than it is today—the dawning of a new civilization that will enable us to transcend our biological limitations and amplify our creativity,” looking at an investment horizon of 100 years or more is downright impossible or impractical to put in practice.

Moreover, given the rapidly evolving dynamics, largely supported by technological innovation, such devotion to interpret a mountain of market historical data defeats Wall’s Street’s basic mantra of “past performances doesn’t guarantee future outcomes.”

So even if bonds have been proven to outperform stocks in the longest run, it doesn’t necessarily translate to the same outcome over the next coming decades.

Lastly, it’s about data mining too. Advocates of one particular cause tend to use time reference points that support their underlying bias, as different time periods yield different results.

However, over the next decade or so we believe that stocks should outperform bonds.

Here are the reasons why.

One, global government in an attempt to reflate the markets has imposed policies, such as massive stimulus spending, a cheap money environment as shown by the steepening of the yield curve [see Steepening Global Yield Curve Reflects Thriving Bubble Cycle] and quantitative easing, that has indirectly been supportive of the equity assets.

Second, under the onus of over indebtedness, afflicted governments have been tacitly inflating away these burdens through inflationary policies. And since inflation erodes a currency’s purchasing power, higher inflation thereby reduces real gains on fixed income.

Third, as governments take on more debt to substitute for declining private sector demand, inflationary policies serve as an indirect way to default on debts.

Fourth, global supply of debt will transcend available capital.

Fifth, the mercantilist inclinations of global governments will employ measures to prevent the necessary adjustments in the values of their respective domestic currency so as to protect “export markets”.

Hence, inflation will likely be a global phenomenon than one limited to debt scourged nations.

Sixth, even in the US, financial asset pricing has increasingly been influenced by inflation more than capital gains.

In fact, it is nearly catching up with dividends. [see our earlier discussion on Worth Doing: Inflation Analytics Over Traditional Fundamentalism!]

Figure 6: Economagic.com: 10 Year Treasury In A Bond Bull Market For 27 years!

Seventh, bonds have been in a bullmarket since the early 80s [see Figure 6], hence ``it would be almost impossible for bonds to generate the same amount of capital gains as they did in the past” argues Peng Chen, Ph.D., CFA, and Roger Ibbotson, Ph.D. (HT: Gully)

This suggests too that the US treasury bearmarket could likely be as long as the last bullmarket (27 years) or the previous bearmarket (30 years).

Figure 7: Manual of Ideas’ Instablog: Tobin’s Q

Lastly, in an inflationary environment the cost of replacing company’s assets would increase, hence stock prices should also adjust to reflect on this changes, based on the Tobin’s Q ratio, or a measure defined by wikipedia.org, ``comparing the market value of a company's stock with the value of a company's equity book value. The ratio was developed by James Tobin (Tobin 1969). It is calculated by dividing the market value of a company by the replacement value of the book equity.”

If the derived value is greater than one then this suggest of overvaluation [as market prices are greater than the company’s assets] and if the value is less than one then it is an indicator of undervaluation.

Notice that during the stagflationary decade of the 70s to the early 80s the Tobin’s Q had largely been undervalued or that stocks were priced below their replacement costs, although stocks and bonds had marginal differences in returns, according to Shawn Allen of Investor’s Friend ``The 20 years from 1966 through 1985 were ugly all around. Stocks came out slightly ahead but were the best of a dismal lot.”

As a caveat, since inflation impacts asset prices relatively, stocks won’t likely perform in a uniform manner and would likely be distinguished based on the industry.

So yes, like Warren Buffett, we think stocks will outperform bonds over this cycle.

How Innovation Have Improved Our Lives

In "100 Things Your Kids May Never Know About" Nathan Barry enumerates the casualties of rapid technological innovation.

From wired magazine, ``There are some things in this world that will never be forgotten, this week’s 40th anniversary of the moon landing for one. But Moore’s Law and our ever-increasing quest for simpler, smaller, faster and better widgets and thingamabobs will always ensure that some of the technology we grew up with will not be passed down the line to the next generation of geeks.

``That is, of course, unless we tell them all about the good old days of modems and typewriters, slide rules and encyclopedias …"

The 100 list...

Audio-Visual Entertainment

1. Inserting a VHS tape into a VCR to watch a movie or to record something.
2. Super-8 movies and cine film of all kinds.
3. Playing music on an audio tape using a personal stereo. See what happens when you give a Walkman to today’s teenager.
4. The number of TV channels being a single digit. I remember it being a massive event when Britain got its fourth channel.
5. Standard-definition, CRT TVs filling up half your living room.
6. Rotary dial televisions with no remote control. You know, the ones where the kids were the remote control.
7. High-speed dubbing.
8. 8-track cartridges.
9. Vinyl records. Even today’s DJs are going laptop or CD.
10. Betamax tapes.
11. MiniDisc.
12. Laserdisc: the LP of DVD.
13. Scanning the radio dial and hearing static between stations. (Digital tuners + HD radio b0rk this concept.)
14. Shortwave radio.
15. 3-D movies meaning red-and-green glasses.
16. Watching TV when the networks say you should. Tivo and Sky+ are slowing killing this one.
17. That there was a time before ‘reality TV.’

Read the rest here

The lists simply shows how our quality of life have vastly been improved by market based innovation.

Morgan Stanley's Stephen Roach: Market's Faces Rude Awakening

Morgan Stanley's Stephen Roach, in a CNBC interview says that markets could be faced with a "rude awakening"

Some excerpts from the interview:
-Visible manifestation of all the excess liquidity that monetary authorities have poured into the system
-Markets are priced for a recovery that’s gonna end up disappointing earnings
-Financial Crisis isn’t over
-75% of global economy still contracting
-Markets are in for a rude awakening
-Green shoots...simplistic way to look at the world
-we are going to have an anemic recovery

Presidential Approval Ratings and Stock Market Returns

An interesting insight by Bespoke Invest on the correlations of Presidential approval ratings and stock market returns.

This from Bespoke Invest, (bold highlights mine)

``When looking at the complete history of approval ratings, it was hard to believe that even though he left office as one of the most unpopular Presidents ever, at one point George W. Bush's approval rating was higher than any other President in the post-WWII era. Ironically, the prior record appears to be held by his father, whose popularity also hit its lowest levels near the end of his first and only term. Likewise, while Reagan has been viewed positively by both Republicans and Democrats, he and Nixon (and Obama so far) are the only post-WWII Presidents who never saw their approval ratings break above 70%.

``Taking the USA Today's look at Presidential approval ratings one step further, we added a chart of the S&P 500's year over year (y/y) performance during each President's term to see how a President's popularity was tied to the stock market. Not surprisingly, there is a strong relationship between the stock market's performance (which reflects the economy) and how a President is viewed. Presidents who were in office while the stock market was strong typically have been more popular and vice versa."

``In recent history, however, the relationship has been less consistent. For example, George W. Bush's popularity peaked when the market was weak, and as the stock market improved up until 2007, his popularity continued to decline. Likewise, while it's still early in his first term, President Obama came into office with an approval rating of 64%, but even though the markets have shown considerable improvement, his approval rating has seen a decline to 55%."

Think of it, the last paragraph suggests that falling popularity for President Obama has been coincidental with rising stock markets so there seems to be a loose connection.

Aside from the attractively colored chart which are meant to amuse, popularity measures seem to be an inaccurate way to evaluate, gauge or predict stockmarket activities, trends or returns. That's because popularity is mostly about superficiality and inherently fickle.

For instance, a popular president who undertakes populist policies may generate short term gains, but reap long term pains and vice versa.

What seem to matter more is the substance and direction of the policies employed.

INO's Adam Hewison on Gold: New Highs in Seven Weeks!

INO.com's Adam Hewison makes a bold prediction based on technical perspective: Gold will reach a new high by the end of August or early September.

Click on image below for Mr. Hewison's explanation:

Disclosure: this blog is a member of INO's affiliate partner program