Seth Klarman's Forgotten Lessons of 2008

Interesting insights from market guru Seth Klarman, courtesy of My Investing Notebook

(all bold highlights mine), [my comments]

In this excerpt from his annual letter, investing great Seth Klarman describes 20 lessons from the financial crisis which, he says, “were either never learned or else were immediately forgotten by most market participants.”

``One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. We all know about the “depression mentality” of our parents and grandparents who lived through the Great Depression. Memories of tough times colored their behavior for more than a generation, leading to limited risk taking and a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior. One state investment board recently adopted a plan to leverage its portfolio – specifically its government and high-grade bond holdings – in an amount that could grow to 20% of its assets over the next three years. No one who was paying attention in 2008 would possibly think this is a good idea.

``Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt- down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

Twenty Investment Lessons of 2008

1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.

[In a world of fiat money, one must realize that bubble cycles are its main feature. It's all a matter of understanding and timing the cycles]

2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.

[Bubble mechanism is generally a feedback loop between prices and collateral values]

3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.

4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.

["Risk comes from not knowing what you are doing" or "the dumbest reason in the world to buy a stock is because it's going up" to quote Warren Buffett.]

5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.

[models function as scientific rationalizations to peddle unrealistic premises]

6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.

7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of "private market value" as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.

8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.

9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.

[For a value investor-yes, averaging down is a commendable approach, but for traders the play is different]

10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.

[the danger from financial innovation stems from elite political entities gaming the system]

11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.

[rating agencies are part of the network of political enterprises]

12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.

13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.

14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.

[leverage is the fuel of all bubbles]

15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.

16. Financial stocks are particularly risky. Banking, in particular, is a highly leveraged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank's management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.

17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.

[Amen!!!!]

18. When a government official says a problem has been "contained," pay no attention.

19. The government – the ultimate short-term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.

20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

[except for leverage speculators, all the rest compose of the political networks]

Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

False Lessons

1. There are no long-term lessons – ever.

[I'd like to add: "Blue chips" are risk free!]

2. Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.

3. There is no amount of bad news that the markets cannot see past.

4. If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.

5. Excess capacity in people, machines, or property will be quickly absorbed.

[digging and filling holes on the ground as proposed by the mainstream will]

6. Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.

7. In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.

[not unless taxpayers shoulder the losses]

8. The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.

[this called confirmation bias]

9. The government can indefinitely control both short-term and long-term interest rates.

10. The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost.

[this is a fairy tale relied upon by the government and the mainstream]

(Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)-[Indeed!!!]

Global CDS Update: World Credit Stress Easing

Here's an update on the world Credit Default Swap (CDS) market from Bespoke Invest.

Based on the Feb 5 lows, as Bespoke observes, ``Portugal default risk is down the most at 40%, followed by Austria (-38%), and Spain (-32%). Vietnam, Argentina, and Egypt are the only countries that have seen default risk increase.

While most of the CDS have been significantly down from the early February anxiety, they are mostly up compared to the start of 2008 except for Lebanon and Kazakhstan.

Such easing of credit concerns adds to our "sweet spot" scenario.

Peak Oil: Where Art Thou?

Unrecognized by many, technology has significantly been improving on the way we do things. This includes finding new and adding to the existing resources that are deemed useful to society.

The chart found below is an example.

True, while oil prices are currently hovering at $80, technology is fast catching up on how unconventional oil is being found.
According to the Economist, (bold highlights mine)

``BP, A big British oil company, announced a round of efficiency measures and cost cuts on Tuesday March 2nd aimed at increasing annual profits by $3 billion over the next few of years. But BP and the world's other big oil companies face similar problems when it comes to boosting profits. Few big new oil fields that are easy to reach and cheap to exploit have been discovered in recent years. This has driven firms to seek oil ever deeper below the sea. In 1947, Kerr-McGee built the world’s first offshore oil well that was completely out of sight of land, drilling 4.6 metres into the seabed off the coast of Louisiana. This year Shell's 22,000-tonne Perdido rig is set to begin operation. Standing nearly as tall as the Eiffel Tower, it is chained to the seabed 2.4km metres below and is capable of extracting oil at a maximum depth of 2.9km."

I'd propose that the problem of high oil prices isn't due to the "perceived" scarcity of oil (or peak oil), but instead with over 90% of proven oil reserves held by governments, the problem is one of the access to these reserves as shown below.

Chart from the US EIA

In short, while government intervention adds to the inaccessibility factor in the supply side, government inflationism (too much printing money, subsidies, etc...) has been prompting for artificially increased demand, which compounds on the market distortions which results to high (and prospectively higher) oil prices.

To consider, technology has materially improved, in spite of the tremendous restrictions and contortions plaguing the oil marketplace.

Had free markets been allowed to function, we'd likely see the wonders of the price mechanism work by having more supplies sooner than later. In addition, markets are likely to discover feasible oil substitutes rather than government imposed options via subsidies.

As Professor Don Boudreaux explains, (bold highlights mine)

``Petroleum was no resource to our ancestors who had yet to grasp the fact that it can be refined and burned in ways that improve the quality of life. In fact, I suspect that whenever that gooey, noxious black stuff appeared in freshwater creeks in pre-Columbian Pennsylvania, natives of that region regarded it as a nuisance.

``So economically, the Earth's supply of nonrenewable energy resources was, back then, much smaller than it is today. Human creativity and effort turned a nuisance into a resource.

``Human creativity and effort also are at work finding not only substitutes for oil, but also new supplies of oil. Each success on this front increases the supply of oil. The reason is that oil deposits that remain unknown are economically nonexistent.

``The same is true of oil deposits that are known to exist but are currently too costly to tap. Oil in the Earth's crust that is out of reach with existing technology is no more of a resource today than is oil on Pluto. But if and when human creativity discovers cost-effective techniques for extracting that oil, it then -- and only then -- becomes a resource. In effect, more of the resource "oil" is created.

``Of course, as a matter of physics, there is indeed only a finite amount of oil in the Earth. But we have no idea how much. And our ignorance of this physical fact is economically relevant."

In short, access to resources is a function of how the market values them, which can only be determined by the price mechanism.

Quality Of Corporate Management As Barrier To Low Wage Competition

Another main reason why the meme of "low wages abroad steal local jobs" is rubbish- is because of the varying quality of management in different types of companies in different nations.

Stanford's Nicolas Bloom and John Van Reenen in their paper "Why Do Management Practices Differ across Firms and Countries?" enumerates why: (all bold highlights mine) [HT: Econlog]

First, firms with “better” management practices tend to have better performance on a wide range of dimensions: they are larger, more productive, grow faster, and have higher survival rates.

Second, management practices vary tremendously across firms and countries. Most of the difference in the average management score of a country is due to the size of the “long tail” of very badly managed firms. For example, relatively few U.S. firms are very badly managed, while Brazil and India have many firms in that category.

Third, countries and firms specialize in different styles of management. For example, American firms score much higher than Swedish firms in incentives but are worse than Swedish firms in monitoring.

Fourth, strong product market competition appears to boost average management practices through a combination of eliminating the tail of badly managed firms and pushing incumbents to improve their practices.

Fifth, multinationals are generally well managed in every country. They also transplant their management styles abroad. For example, U.S. multinationals located in the United Kingdom are better at incentives and worse at monitoring than Swedish multinationals in the United Kingdom.

Sixth, firms that export (but do not produce) overseas are better-managed than domestic non-exporters, but are worse-managed than multinationals.

Seventh, inherited family-owned firms who appoint a family member (especially the eldest son) as chief executive officer are very badly managed on average.

Eight, government-owned firms are typically managed extremely badly. Firms with publicly quoted share prices or owned by private-equity firms are typically well managed.

Ninth, firms that more intensively use human capital, as measured by more educated workers, tend to have much better management practices.

Tenth, at the country level, a relatively light touch in labor market regulation is associated with better use of incentives by management.

My comment:

In short, there isn't a single type of management, as much as there is no single class of product or markets or labor or capital.

In the above chart, the US ranks the highest so as with other export giants.

So it would be fallacious and oversimplistic to generalize that investments are only sensitive to the cost of wages, when there are myriads of variables affecting investments.

From Noble To Cruel Intentions: The Chemist's War of Prohibition

This article from Slate Magazine is a lurid example of how government policies that are initially meant to attain noble goals turn up as violating human right to life and liberty. (hat tip: Cafe Hayek)

As the Chicago Tribune editorial quoted by article in 1927, ``It is only in the curious fanaticism of Prohibition that any means, however barbarous, are considered justified."

Some excerpts... (bold emphasis mine)

``Frustrated that people continued to consume so much alcohol even after it was banned, federal officials had decided to try a different kind of enforcement. They ordered the poisoning of industrial alcohols manufactured in the United States, products regularly stolen by bootleggers and resold as drinkable spirits. The idea was to scare people into giving up illicit drinking. Instead, by the time Prohibition ended in 1933, the federal poisoning program, by some estimates, had killed at least 10,000 people.

``Although mostly forgotten today, the "chemist's war of Prohibition" remains one of the strangest and most deadly decisions in American law-enforcement history. As one of its most outspoken opponents, Charles Norris, the chief medical examiner of New York City during the 1920s, liked to say, it was "our national experiment in extermination."

The origins...

``The saga began with ratification of the 18th Amendment, which banned the manufacture, sale, or transportation of alcoholic beverages in the United States.* High-minded crusaders and anti-alcohol organizations had helped push the amendment through in 1919, playing on fears of moral decay in a country just emerging from war. The Volstead Act, spelling out the rules for enforcement, passed shortly later, and Prohibition itself went into effect on Jan. 1, 1920.

The unintended consequences...

``But people continued to drink—and in large quantities. Alcoholism rates soared during the 1920s; insurance companies charted the increase at more than 300 more percent. Speakeasies promptly opened for business. By the decade's end, some 30,000 existed in New York City alone. Street gangs grew into bootlegging empires built on smuggling, stealing, and manufacturing illegal alcohol. The country's defiant response to the new laws shocked those who sincerely (and naively) believed that the amendment would usher in a new era of upright behavior."

The circumvention of laws, the counter policies and the aftermath....

``Rigorous enforcement had managed to slow the smuggling of alcohol from Canada and other countries. But crime syndicates responded by stealing massive quantities of industrial alcohol—used in paints and solvents, fuels and medical supplies—and redistilling it to make it potable.

"Well, sort of. Industrial alcohol is basically grain alcohol with some unpleasant chemicals mixed in to render it undrinkable. The U.S. government started requiring this "denaturing" process in 1906 for manufacturers who wanted to avoid the taxes levied on potable spirits. The U.S. Treasury Department, charged with overseeing alcohol enforcement, estimated that by the mid-1920s, some 60 million gallons of industrial alcohol were stolen annually to supply the country's drinkers. In response, in 1926, President Calvin Coolidge's government decided to turn to chemistry as an enforcement tool. Some 70 denaturing formulas existed by the 1920s. Most simply added poisonous methyl alcohol into the mix. Others used bitter-tasting compounds that were less lethal, designed to make the alcohol taste so awful that it became undrinkable.

``To sell the stolen industrial alcohol, the liquor syndicates employed chemists to "renature" the products, returning them to a drinkable state. The bootleggers paid their chemists a lot more than the government did, and they excelled at their job. Stolen and redistilled alcohol became the primary source of liquor in the country. So federal officials ordered manufacturers to make their products far more deadly."

Gruesome.

Read the rest of the article here

As self-development author Robert Ringer rightly argues, ``just because government mandates something to be right or wrong doesn’t mean that it is right or wrong. If a government mandate calls for the violation of even one individual’s sovereignty, it is wrong in the eyes of Natural Law — or what can also be referred to as the Law of Non-aggression. Aggression is always the sacred measuring stick of right and wrong — period."

Global Stock Market Update

Bespoke Invest provides an update of global markets from two perspective: advance from the recent February 8 lows and a year to-date performance.
According to Bespoke:

``Sixty-five out of the 81 country indices listed below are up since the markets made their recent correction lows on February 8th. As shown, Greece (the country causing everyone to get all worked up recently) is up the second most of any country shown since 2/8 with a gain of 11.92%. The Ukraine is up the most with a gain of 12.69%. Brazil has been the best performing BRIC country with a gain of 7.88%. Five of the seven G7 countries are doing better than three of the four BRIC countries since the recent lows. Britain, Canada, the US, France, and Germany are all up more than Russia, India, and China during the most recent rally. For the year, 44 out of 81 countries are in positive territory, with Estonia, Ukraine, and Bangladesh leading the way. The US is outperforming all four BRIC countries so far in 2010. Slovakia, Dubai, and Spain have been the worst performing countries this year, all with declines of more than 10%."

I'd like to add that while indeed the G7 has generally outclassed the BRIC and major emerging markets, I wouldn't count on this phenomenon to last.

Second, it is noteworthy to see the Philippines stage a strong comeback from the recent lows and place among the top ten. I'd be more comfortable to see our neighbors close the gap.

Lastly despite brouhaha over Greece, as pointed out by Bespoke, she is the second best performer since the Feb low but still down for the year. One would note that the Baltic states which had been slammed hard at the height of the crisis, has now outperformed the world for the year. We can't underestimate similar performances from the PIIGS as the crisis breezes over. But again, every nation have their own quirks.

John Law, Paper Money and the Mississippi Bubble

Another very informative stuff from Mises Blog (Jeffrey Tucker).

This cartoon video shows of John Law's experiment with paper money that sparked the Mississippi bubble.

History indeed rhymes.

Econ 101: Prices, Profits, and Resource Misallocations From Interventionism

This short but insightful documentary video from Mises Blog shows of the basic functionality of profits to society- in contrast to the evil portrayal by the mainstream and politicians.

Where Is Deflation?

``In reality, Britain has the worst of all possible worlds: a stagnant economy, a crippling budget deficit and rising prices. The Keynesian consensus is that things would have been far worse without the stimulus provided by government. And if the economy isn’t pumped up with inflated demand, it will collapse back into recession. If it’s not working, that just proves the stimulus should be even larger. It is the argument quacks always push: If the medicine isn’t working, increase the dosage. And yet, reality has to intrude into this debate at some point. The deficit can’t get much bigger, interest rates can’t be cut much lower, and sterling can’t lose much more value. Stimulating the economy isn’t working. In fact, it’s only making it worse. Consumers and businesses don’t want rising taxes. A falling currency pushes up the cost of everything the U.K. imports, stoking inflation. Savers get decimated, and yet the banks remain reluctant to lend because they rightly believe the economy is in the doldrums.” Matthew Lynn, Deathbed of Keynesian Economics Will Be in U.K.

When deflation advocates point to charts of bank loan activities, the money multiplier or Treasury Inflated Protected Securities (TIPS) and proclaim “where is inflation?” - they seem to be asking the wrong question.

Figure 1 St. Louis Fed/Northern Trust: M1 Money Multiplier and Consumer US CPI

For instance, while it is true that the US M1 money multiplier[1] is down, (as shown in the left window in figure 1 and recently used by a popular analyst as example), there seems hardly a grain of truth that the falling money multiplier equates to sustained deflation in US consumer prices (right window).

In other words, if they are correct then obviously CPI should be adrift in the negative territory- to reflect on deflationary pressures until the present. Yet the CPI, both in the ALL items and ALL items LESS Food and Energy remains in the positive zone, in spite of, or even in the face of these ‘deflation pressure’ statistics; falling money aggregates, subdued TIPS and or lackluster bank activities.

And CPI turned negative only at the height of the crisis, which makes it more of an aberration than the norm. Of course, this counterpoint extends to the validity of the accuracy of the US government’s measure of inflation, which I am a skeptic of.

However, here are more of our counterarguments to the sarcastic question of “where is inflation?”:

1. Reading current performance into the future.

Deflation exponents insist that “deflationary pressures” ought to collapse the markets as they did in 2008. They’ve been doing so for the entire 2009. But this hasn’t been happening. That’s because the reality is, we haven’t been operating under the same ‘Lehman’ conditions of 2008!

The US government’s actions to effect a cumulative network of local and international market patches, as seen in the various ‘alphabet soup’ of emergency programs plus a raft of guarantees to the tune of over $10 trillion, swaps and direct expenditures (quantitative easing), seems to ensure of such non-repetition, as we have repeatedly discussed.

So more banks could indeed fail, the FDIC upgraded its watchlist from 552 to 702 banks in danger, but the liquidity gridlock of 2008 isn’t likely to happen. That’s because the Fed has a morbid fear of ‘deflation’ than warranted, and is likely to engage in a “whack a mole”; pouring liquidity on every account of the emergence of deflation.

Let me clarify that the US banking system is a solvency issue, but this is not the case for Asia or for major emerging markets. Ergo, the contagion from the Lehman collapse of October 2008 emanated from a liquidity shortfall as US banks seized up. Since today’s scenario is different, then predicting the same contagion seems unlikely, so any arguments calling for a 2008 scenario is like calling a banana an apple.

Besides, the Fed’s manipulation or “nationalization” of key markets such as the US mortgage markets seems to have been designed to stave off the odds of having a domino effect collapse in their banking industry. This, by keeping the banking system’s balance sheets afloat, through “elevated” or inflated prices. In spite of babbles for so-called exit strategies, this isn’t likely to change.

On the contrary, a broader view of markets appears to be suggesting that inflation looks likely a future or prospective phenomenon.

To consider, if any of these “deflationary” stats begin to recover then they are likely add to ‘inflation expectations’ and thus eventually reverse the current state of “deflation subdued” CPI .

2. Misleading Interpretation of Hyperinflations.

Hyperinflations have never been caused by excessive consumer borrowings, never in history. To paint of such an impression is to egregiously mislead.

Hyperinflations have basically been caused by insatiable government spending, whose exponential growth had been financed by the printing press. On the other hand, a credit boom from consumer borrowing is most likely to result in bubble (boom-bust) cycles and not hyperinflation.

The fundamental difference is that of the political goal; in boom bust cycles, government’s role to inflate the system is largely indirect-with mostly the goal to perpetuate ‘quasi’ economic boom conditions by inflating money supply and by skewing the public’s incentives through regulation or taxation to favoured political sectors, as in the case of the recent real estate-mortgage bubble.

Whereas, in hyperinflations, the government’s role is more direct, usually deliberate or represents an act of desperation to meet a political goal for the incumbent leadership, such as perpetuation of power (e.g. Zimbabwe), or the addiction to inflationism compounded by policy errors based on theoretical misunderstandings[2], as Germany’s Weimar hyperinflation experience, and not from war reparations as others have suggested[3].

Of course one may argue that there is always a possibility of first time. Perhaps.

3. Selective Perception And Misguided Expectations

Many deflation proponents tend to argue from the perspective of the private sector’s performance in the economy. Their propensity to “tunnel” or fixate into the private sector leads them to erroneously omit the impact of the rapidly bulging share of the US government’s contribution to the economy, which presently accounts for nearly a third.[4]

Ignoring government’s contribution and policy impacts to the economy renders a handicapped analysis.

Nevertheless, looking at the global scale, we seem to be seeing more incidences of a ‘quickening’ of consumer price inflation, as in Malaysia and in Brazil, aside from previous accounts in China, India, Vietnam, and even to the real estate bubble-banking crisis afflicted UK which saw consumer price inflation rise to its highest level since November 2008 (see figure 2)-where debt deflation has been the generally expected outcome by the mainstream.

Figure 2: Finfacts.ie/stockcharts.com: Surging UK Inflation, Devaluing UK Pound

Reporting on the surprising resilience on UK’s inflation (left window), according to Finfacts.ie. ``The ONS said the CPI fell by 0.2% between December and January. Although negative, this is the strongest ever CPI growth between these two months (prices typically fall at a faster rate between December and January). This record monthly movement is mainly due to the increase in January 2010 in the standard rate of Value Added Tax (VAT) to 17.5% from 15% and, to a lesser extent, the continued increase in the price of crude oil. In the year to January, the all items retail prices index (RPI) rose by 3.7% up from 2.4% in December. Over the same period, the all items RPI excluding mortgage interest payments index (RPIX) rose by 4.6%, up from 3.8% in December.” (bold highlights mine)

Why should oil prices rise if demand has been declining as the Fisherian and Keynesian deflationists experts allege? From a “money is neutral” perspective, wouldn’t that be a paradox?

Also, why should higher taxes become inflationary, when all it does is to distort the economic structure by shifting investments from private to the public, as well as, to decrease the incentives for the private sector to participate?

Murray Rothbard provides the answer[5], ``If inflation has been under way, this “excess purchas­ing power” is precisely the result of previous governmental in­flation. In short, the government is supposed to burden the pub­lic twice: once in appropriating the resources of society by in­flating the money supply, and again, by taxing back the new money from the public. Rather than “checking inflationary pres­sure,” then, a tax surplus in a boom will simply place an addi­tional burden upon the public. If the taxes are used for further government spending, or for repaying debts to the public, then there is not even a deflationary effect. If the taxes are used to redeem government debt held by the banks, the deflationary ef­fect will not be a credit contraction and therefore will not cor­rect maladjustments brought about by the previous inflation. It will, indeed, create further dislocations and distortions of its own.” (bold highlights mine)

In short, what could easily be seen is that the inflationary effects of bailouts, subsidies and its domestic version of quantitative easing programs have gradually been manifesting on her devaluing currency first (right window), and next, to consumer prices. And the newly increased VAT in the UK only adds to the existing distortions already in place.

Of course this account of emerging inflation seems to have befuddled the mainstream anew.

Yet, this dynamic is likely to emerge in the US too...perhaps soon.

For us, another reason why inflation is still quiescent in the US; aside from the slack in the banking system out of the reluctance to lend due to balance sheet concerns, is because of the natural belated response to the record steepness in the yield curve.

The uncertainty arising from the abrupt market cleansing adjustments and the rediscovery phase of where resources are needed, implications of new regulatory regime, prospects of higher taxes to pay for the slew of stimulus programs, risks of more government interventions, impaired and unsettled balance sheets of banks and financial institutions mired in the bubbles have all conspired to inhibit investors from taking advantage of the steepness in the yield curve.

Yet the past has shown that eventually zero interest rates and a steep yield curves will likely artificially impact the credit process to jumpstart a new boom-bust cycle. Although we aren’t likely to believe that a boom phase of a bubble cycle could happen in sectors recently affected by a bust, any seminal bubbles will most likely diffuse into other sectors untainted by the recent bubble (technology or materials and energy?) or percolate outside of the US.

This implies that the ramifications from policies are likely to gain traction with a time lag, as had been in the past.[6]

Hence, expectations for the immediacy of the markets’ response from policies have not been only myopic but also constitutes as wishful thinking-anchoring on a belief that people don’t respond to incentives.

4. The Folly Of Excluding The Role of the US dollar And Other External Forces

In addition to the lagged response, it is likely that the US dollar, as the world’s de facto seignorage provider, has the privilege to extend its inflationism outside her shores hence, inflation becomes a precursory tailwind (see figure 3)

Figure 3: St. Louis Fed: CPI (red) versus US Trade Balance (blue)

Recessionary forces around the world, as exhibited in gray shaded areas in both the 2000 and the present crisis, required diminished US dollar financing for global trade. This led to an improvement of the US trade balance (red line), which none the less, dampened US CPI inflation (blue line).

As the world recovered from the recession or the crisis, trade deficits surged anew to reflect on the revitalization of global trade. And the US CPI eventually followed suit. One could observe that the CPI trailed trade deficits by a short interval in both accounts.

And also given that today’s situation is vastly different from the 2000-2007, where the slack in private expenditures have been replaced by monstrous government spending, the impact from the surging “twin” deficits will likely have a more meaningful impact. First, this will be reflected externally, as in the account of emerging inflation ex-US, and possibly channelled via the US dollar relative to other currencies or if not through commodities. Next, this gets manifested on the US domestic consumer price indices.

Therefore the interstice, where CPI inflation seems subdued, should be known as inflation’s “sweet spot”, perhaps where we are today.

Hence the idea that slow inflation today equals slow inflation tomorrow predicated on the money multiplier and an impaired credit process, seems to grossly underestimate on the repercussions of inflationary policies because, aside from the lagged impact from yield curve and the blatant disregard of the expanding share of the US government in the economy, such analysis discounts on the effects of exogenous forces, particularly the US dollar’s role as chief financier of global trade, and the underlying transmission mechanism from external ‘inflation’, such as competitive devaluations, impact on nations with pegged currencies-a core to periphery phenomenon. This is, aside from, misconstruing money’s role as having neutral effect on the economy.

In other words, markets and economic trends will depend on the directions of ensuing policy actions, by major economies most especially the US, to ‘reflate’ the system.

And given that Fed Chairman Ben Bernanke was again shown as seemingly in a cautious stance about the “halting” pace of economic recovery for the US from which he reassured Congress of an extended regime of low interest rates and where in addition to the apparent mounting clamour of adopting a philosopher’s stone as mainstream policy, as discussed last week[7], more professional entities seem to be joining the chorus for extended inflationism, such as the latest joint project by Goldman Sachs [Economists Jan Hatzius] Deutsche Bank [Peter Hooper], Columbia University [Frederic Mishkin], New York University [Kermit Schoenholtz] and Princeton University [Mark Watson] who arrived at the conclusion that current conditions remain tight despite the Fed’s efforts.

We don’t need to actually wish for it, but evidently, the pronounced lobbying to justify more inflationism is likely to be music in the ears for the current crops of political and technocratic overseers.

So the question of “where is inflation?”, should be substituted with the opposite, given the limited and sporadic accounts of ‘deflation statistics’, the question should be “Where is Deflation?”

As markets haven’t been collapsing and as the world have elicited signs of rising incidences of inflation, the onus of proof, is on them.

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[1] coins, currency, checkable deposits demand deposits and travellers checks from wikipedia.org

[2] “The government and the Reichsbank both believe that monetary troubles arise from an unfavorable balance of payments, from speculation and from unpatriotic behavior of the capitalist class. They therefore attempt to fight the menace of depreciation of the Reichsmark by controlling dealings in foreign currency and by confiscating German holdings of foreign assets. They do not understand that the only safeguard against the fall of a currency's value is a policy of rigid restriction. But though the government and the professors have learned nothing, the people have. When the war inflation came nobody in Germany understood what a change in the value of the money unit meant. The business-man and the worker both believed that a rising income in Marks was a real rise of income. They continued to reckon in Marks without any regard to its falling value. The rise of commodity prices they attributed to the scarcity of goods due to the blockade. When the government issued additional notes it could buy with these notes commodities and pay salaries because there was a time lag between this issue and the corresponding rise of prices. The public was ready to accept notes and to keep them because they had not yet realized that they were constantly losing purchasing power.” Ludwig von Mises, The Great German Inflation, Money, Method, and the Market Process ch 7

Money, Method, and the Market Process

[3] See Wikipedia.org, Inflation in the Weimar Republic

[4] See previous post, It’s Not Deleveraging But Inflationism, Stupid!

[5] Murray N. Rothbard, Chapter 12—The Economics of Violent Intervention in the Market, Man Economy and the State

[6] See our previous discussion, What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?

[7] See Why The Hike In The Fed’s Discount Rate Is Another Policy Bluff

Inflation’s Sweet Spot Augur For A Gold Breakout And Global Equity Market Rally

``When the government and the banking system begin inflating, the public will usually aid them unwittingly in this task. The public, not cognizant of the true nature of the process, believes that the rise in prices is transient and that prices will soon re­turn to “normal.” As we have noted above, people will there­fore hoard more money, i.e., keep a greater proportion of their income in the form of cash balances. The social demand for money, in short, increases. As a result, prices tend to increase less than proportionately to the increase in the quantity of money. The government obtains more real resources from the public than it had expected, since the public’s demand for these resources has declined. Eventually, the public begins to realize what is taking place. It seems that the government is attempting to use inflation as a permanent form of taxation. But the public has a weapon to combat this depredation. Once people realize that the govern­ment will continue to inflate, and therefore that prices will con­tinue to rise, they will step up their purchases of goods. For they will realize that they are gaining by buying now, instead of wait­ing until a future date when the value of the monetary unit will be lower and prices higher. In other words, the social demand for money falls, and prices now begin to rise more rapidly than the increase in the supply of money."-Murray N. Rothbard,The Economics of Violent Intervention in the Market

Speaking of benign inflation, the “sweet spot” of the inflation is the seductive phase where the financial and economic ambiance is characterized by an episode of rising asset prices which reinforces the perception of the strengthening of the economy’s recovery and vice versa.

This actually plays out in the manner introduced by market savant George Soros as the reflexivity theory- a self-reinforcing feedback loop mechanism where people interpret prices as signifying real events, and where real events reinforce these price signals.

In short, from our perspective, the sweet spot of inflation represents as a boom scenario for markets resulting from easy money policies.

However, since the interplay of perceptions which have been enhanced by price signals and statistical information on the real economy has been manipulated by the official policies, most people don’t recognize that price signals are manifestations of the deepening scale of malinvestments into the system. And as the boom phase draws in more of the crowd, the trend becomes entrenched until they become unsustainable...but we seem to be getting way too far.

A Global Rally Ahead?

Last week we said that equities are likely to be a “buy” once gold breaks above the 1,120-1,125 area[1]. And perhaps the sweetspot of inflation will become more conducive once it is supported by the concomitant rise of US and Chinese markets.

The reason we opted to use gold as a major key indicator for markets is because gold has not only decoupled from the US dollar and is likely to seek its own path overtime, but importantly gold has served as a significant lead indicator for equity and commodity prices. This is because Gold apparently reflects on the state of the global liquidity.

For now, even as gold hasn’t broken above the important threshold, the ancillary conditions appear to be suggestive of an upcoming breach (see figure 4)

Figure 4: stockcharts.com: Sweet spot of Inflation?

US equities as signified by the S & P 500 (SPX), while down for the week, has brushed off the recent accounts of the volatility from the ‘Greek tragedy’ and appears to be in an uptrend.

We also see China’s Shanghai index (SSEC) as striving to move higher (see middle minor window). China’s major bellwether have been in consolidation over the past two months, after being hammered repeatedly by the formal and informal arm twisting by her government in an attempt to squeeze bubbles out of her system late last year.

Next we have the JP Morgan Emerging Markets Debt fund (JEMDX) or a bond fund which is invested in sundry emerging market sovereign debt, as sharply moving higher. These could be signs that foreign money flows could be gathering steam into Emerging Markets anew.

Combined, these market signals could presage a vigorous resurgence of global equities out of “loose monetary conditions” and the reflexivity theory ahead.

And this is likely to also be reflected in gold’s next moves.

Gold’s ‘Fundamental Change In Sentiment’

Another reason why gold should be a good benchmark is that the varying interests of global central banks appear to have created a “neutral” zone for gold.

By neutral zone, we mean that gold is likely to reflect on market forces with reduced odds of manipulation. Many emerging market governments have been increasingly playing the role of “buyer” while former sellers seem to be downscaling sales activities.

Asian Investors quotes the World Gold Council on this noteworthy shift, ``After net-selling an average of 444 tonnes of gold in the five years to 2008, central banks only offloaded a net 44 tonnes last year. In fact, after 62 tonnes of net selling in the first quarter of 2009, central banks posted three quarters of net buying. This shift may signal a "fundamental change in sentiment", says the London-based World Gold Council (WGC).” (bold highlight mine)

In other words, the “fundamental change in sentiment” has transformed central bank officials’ view of gold from a “barbaric metal” to insurance, as previously discussed.[2]

I’d like to further add that gold prices have recently been weighed by the IMF’s proposed sale of the remaining 191.3 tons to the market.

While after a week of announcement, no nation has officially taken up the IMF’s offer, there are reports that India may suit up for IMF’s last batch of gold sales. This should stir up the gold market anew.

Many have expected China to take the counterpart of the IMF’s offer. But this may not happen. China’s gold procurement has been marked by inconspicuous domestic acquisitions since. As example, in April of last year, China surprised the market with the declaration that it had raised its gold reserves by “33.89 million ounces by the end of April” of 2009 since December 2002.

And since China is now the world’s largest gold producer, she isn’t likely to be pressured on overtly buying into IMF’s gold.

Albeit, we are quite sure that China’s interest in the precious metal remains unabated. Her huge sovereign wealth fund, China Investment Corporation (CID) had reportedly acquired an equivalent of 4.5 tonnes of SPDR Gold Trust ETF just recently, making the fund the largest holder, alongside with investing legends as John Paulson and George Soros.

Finally, should gold opt to somewhat mimic on the Euro’s moves anew, the prospects of a sharp rebound in a severely oversold Euro could also give the metallic money a boost (see figure 5)

Figure 5: Mineweb: Extremely Overbought US dollar and Severely Oversold Euro

Here we quote Mineweb’s Rhona O'Connell: (bold emphasis mine)

``The instrument shown here is the US Dollar Index position reported by the "I.C.E.", or IntercontinentalExchange, which turns over very heavy dollar trading, although the net speculative positions are comparatively low when compared with those in the euro on the CME or gold on COMEX. Nonetheless they reflect sentiment. The reported positions relate to contracts of $1,000 each, meaning that the largest recent net dollar short position, at 12,521 contracts, was equivalent to $12.5 million. The swing since then has been equivalent to $53.4 million to the long side and the latest position, a net long of $40.9 million, is almost 150 times the average since 2004.

``Meanwhile the net euro position on the CME is even more extreme. Taken over the same period, the net speculative euro position on the Chicago Mercantile Exchange has averaged a long of $4.8 billion euros. In mid-February the position was a net short of 8 billion euros; the outright long is at 71% of the average for the period, but the short is twice its average.”

So the forces which heightens the odds for an upside breakout for gold prices looks firming up, and we should gold’s breakout to likely be accompanied by auspicious sentiment for the asset markets.

Positive Foreign Trade For The Philippine Stock Exchange

I’d like to conclude with a chart of the foreign flows into the Philippine Stock Exchange (PSE) (see figure 6)

Figure 6: PSE: Net Foreign Trades

Despite the marked selling in early February, we are generally seeing net foreign inflows into the PSE on a year to date basis.

This squares with our earlier observation that despite the diminishing share of foreign trade in the markets (about 37.7%), foreign trade has accounted for a net inflow to the tune of 5.2 billion pesos (about $110 million) for 2010.

Inflationism in developed economies is likely to spur more foreign fund inflows, which should support the domestic asset markets, particularly, the equity market, the real estate sector, corporate and sovereign bonds and the Philippine Peso.

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[1] See Asia’s Policy Arbitrage, Phisix And The Bubble Cycle

[2] See Is Gold In A Bubble?

8 Reasons Why Canadian Banks Have Been Crisis Resilient

Professor Mark Perry enumerates 8 reasons why Canadian banks has proven to be repeatedly resilient during crisis times and has outperformed its US contemporaries.


The scoreboard:

Number of bank failures during the 1930s: United States: 9,000, Canada: 0

Number of Bank Failures during S&L crisis (1980s-90s) United States: Almost 3,000, Canada: 2

Number of Bank Failures during the Great Recession (2007-2010) United States: 196, Canada: 0

Delinquency Rate for Home Mortgages in December 2009 United States: 9.47%, Canada: 0.45%

The 8 Reasons:

1. Full Recourse Mortgages in Canada.
2. Shorter-Term Fixed Rates in Canada
3. Mortgage Insurance Is More Common in Canada than in the United States.
4. No Tax Deductibility of Mortgage Interest in Canada.
5. Higher Prepayment Penalties in Canada.
6. Public Policy Differences for Low-Income Housing.
7. Differences in Canada’s Bank Concentration and Greater Diversification.
8. A Few Other Differences that Contribute to Bank Safety in Canada.

Bottom Line: Taken together, the features and regulations of banks in Canada outlined above create a healthy and sound “pro-lender” environment absent of political motivations for outcomes like greater homeownership, compared to the often politically motivated “pro-borrower” and “pro-homeowner” policies of the United States. While Canada’s banking system has promoted responsible borrowing and prudent lending and underwriting practices with little politically motivated interference, the U.S. banking system seems to have encouraged excessive lending to risky borrowers because of the political obsession with homeownership.(emphasis added)

Read the rest here

Philippine Election Myth: "I Am Not A Thief!"

"Delusions are states of refuge. The mind, unable to comprehend realities or to deal with them, finds its ease in superstitions, beliefs and modes of irrational procedure. It is easier to believe than to think." Garet Garrett

Elections operate on a spectrum of irrationality. That’s because voters tend to cling on to absurd mushy beliefs while candidates reinforce this by peddling drivels.

In the Philippines, corruption appears to be the single most crucial issue that could determine the outcome of the next political leadership. And it’s been the primary focus of the campaign trail.

And it’s why most of the political missives I’ve seen (through email messages) have been fixated on innuendo or character assassinations (ad hominem). And it also why leading protagonists have engaged in an outlandish squabble over slogans like “I am not a thief!”

Yet common sense tells us that NONE of these leading candidates are likely to cleanse the mythological Augean stables.

We can even see this from just one aspect: Election spending.

Measured in ad spending alone the top 6 candidates have already spent an estimated “real ads spending” of 2.1 billion pesos and counting!

Unless these candidates are doing it for charity, elementary inference tells us that these are “investments” will eventually extrapolate to “investment returns” by the winning party.

With the salary of Philippine President pegged at 300,000 per year (Wikipedia). You’d wonder why so much moolah is being put to risks for the top spot (by the candidates, sponsors, friends, alliances et.al.).

But the perspective changes when one realizes that the Office of the President’s budget is at an estimated Php 4.259 billion annually.

In addition, with 1.54 trillion ($327 billion) pesos earmarked for government spending in 2010, then one would reckon that there’s simply tons of money to be made with by the winning team through “political endowment” or “privileges”- political concessions, monopoly, behest loans, subsidies, silent partnership in public-private programs, undeclared fees etc...

This is otherwise known as crony capitalism.

As Murray Rothbard describes on why political leaders needs an elite group...

"the chief task of the rulers is always to secure the active or resigned acceptance of the majority of the citizens. Of course, one method of securing support is through the creation of vested economic interests. Therefore, the King [President] alone cannot rule; he must have a sizable group of followers who enjoy the prerequisites of rule, for example, the members of the State apparatus, such as the full-time bureaucracy or the established nobility. But this still secures only a minority of eager supporters, and even the essential purchasing of support by subsidies and other grants of privilege still does not obtain the consent of the majority."

In short, political privileges endowed to core groups are key to the preservation of power by the political leadership. Or simply said, keeping certain interests groups happy, who will work to control or contain the majority, ensures the tenure of power by the political leadership.

Hence, election spending alone is a great indication that none of the campaign promises (on corruption) will likely be met.

Though the ideal is to vote for candidates with little spending and or with a small political baggage. But this isn’t likely to happen, because democracy is a popularity contest!

Yet for voters earnestly believing that their choice of candidates will represent “change”, regardless of such facts, I’d quote Professor Bryan Caplan’s views on why he thinks voters are irrational, ``Even when his views are completely wrong, he gets the psychological benefit of emotionally appealing political beliefs at a bargain price.”

As an old saw goes, the more things change, the more they stay the same....