Opinions and observations expressed on this blog reflect the authors' individual experiences and should not be construed to be financial advice. None of the members of this blog are licensed financial advisors. Please consult your own licensed financial advisor if you wish to act on any recommendations here.

Thursday, September 30, 2010

Economic Report from the Onion

The greatest news source on Earth has decided to do a report on the economy. It is very insightful. http://www.theonion.com/articles/something-about-tax-cuts-or-earnings-or-money-or-s,18169/

Monday, September 27, 2010

Just how volatile are global politics right now?

Very, it turns out.

Labour now polls even or possibly ahead of the Tories in the UK just four months or so after the most recent election. http://itn.co.uk/6ec09e8f6e13a874aa91c427f4437806.html

Normally I would say ignore politics, but I think what you may be seeing in a number of countries is a move by many democracies toward being ungovernable. That is a risk that we have to keep in mind as the economies of the developed world remain languid. Germany's government is precariously positioned and that is unlikely to improve. The same goes for Australia's. One basic rule of history that I remind myself of when there are situations like this one is that it doesn't necessarily have to end well.

We still haven't seen any headlong plunges toward protectionism by any major parties around the world in order to garner votes, but that's certainly a possibility. It would be a big vote getter in countries that are convinced that all they have to do is improve their trade balance to grow their economies. However, given that all countries seem to be trying to collectively devalue their currencies, it is a possibility trade protections will start popping up. One serious aggravating factor there is that China operates behind somewhat of a trade wall while most of its trade partners are as open as any economies have ever been.

If we do see parties start to flap their gums about protectionism, suddenly even low yielding bonds would look attractive. We aren't there yet, but we could be before long.

Sunday, September 26, 2010

Opposing Views on Gold and GOOG

I have recently been critical of both gold and Google (GOOG). In the interest of presenting multiple views, here are a couple of articles disagreeing with what I have been saying lately.

Gold: http://money.uk.msn.com/investing/articles.aspx?cp-documentid=154762364

The basic premise here is that since we are still at a time when central banks seem to be focused on devaluing their currencies in order to boost exports. I would agree that in the short run this provides some support to gold. Still, I don't buy the win-win scenario for gold because if gold is truly an asset class for all seasons, even a marginally efficient market would have already priced it as such. The risk to gold is that if stable economic growth is restored without an major outbreak of inflation it will suffer horribly. A restoration of 2-3% inflation is not bullish for gold. However, this author makes his case and it helps to have opposing views.

Google: http://blogs.marketwatch.com/cody/2010/09/23/googles-headed-to-2000-heres-why/

Now, there the author says that Google is going to $2000 a share by 2020, which would be about a 4x increase. I actually don't doubt that as a possibility, but I would be inclined to take the under on that one. There is plenty of upside for Google and it is true that the major trends are with them, but a decade is a long time in information technology and Google seems somewhat undisciplined in terms of achieving good operating results. I do think that Google makes a great deal of sense as a long term holding as I have a hard time figuring how it doesn't outperform the overall market over the next several years. Google just frustrates me because they could be more profitable than they are if it was a more professionally managed company.

Saturday, September 25, 2010

A (Very) Brief Digression on Economic History

I normally wouldn't want to venture into this territory, but there are certain facts which have been distorted somewhat due to the fact that this is a political season and somewhat due to the fact that some people want to push certain narratives. I just wanted to provide some simple facts that I think have gotten distorted.

One is that the 1970s were an absolutely hellish decade while the 1980s were wall to wall prosperity. This is true when it comes to the performance of financial markets where stocks had a wretched decade in the 1970s, largely due to the fact that they entered the decade with elevated valuations due to the run ups in the 1950s and 1960s, but also because interest rates rose throughout the decade due to inflation from the Federal Reserve's incompetent management of monetary policy (and due to certain oil producing countries behaving badly).

However, in terms of income growth it certainly wasn't horrible. Here are the CAGR numbers for inflation adjusted personal income by decade.

1950s: 4.06%
1960s: 4.62%
1970s: 3.50%
1980s: 3.13%
1990s: 3.07%
2000s: 2.48%

The same holds reasonably close with GDP, which shouldn't be a surprise since income growth and GDP should be closely related.

Part of the reason the stock market was so nicely positioned for a good decade in the 1980s was that nominal earnings had risen substantially during the 1970s while nominal stock prices remained practically constant, even down somewhat. As a result, stocks in the first few years of the 1980s were badly undervalued. The PE ratio of stocks in April of 1980 was about 7x trailing earnings. Once interest rates began to fall to more reasonable levels, stocks appeared badly undervalued.

If there's a lesson from this it is probably that you should always look up data yourself rather than believe it wholesale from someone who is trying to make an ideological point or create some kind of narrative of the financial markets.

Wednesday, September 22, 2010

August Home Sales and July House Prices

Over from Calculated Risk, we have a preview of existing home sales: http://www.calculatedriskblog.com/2010/09/existing-home-sales-preview.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed:+CalculatedRisk+(Calculated+Risk)

Given that the weekly MBA purchase index has basically not moved in a while and the current levels of pending home sales, the 4.1 million SAAR makes sense.

In terms of what this means for prices, generally inventories over an eight months supply imply moderately to steeply falling prices though the relationship is not ironclad. We did see out of the FHFA today that home prices in July fell 0.5% from June. Given that there is a bit of a lag between when inventory to sales ratios surge and prices drop, we should expect fairly steady small to moderate price declines for many months to come. Currently, a number of forecasts are calling for about a 5-7% decline. Based on some regression work I've done, that seems reasonable.

An interesting consequence of that is that it makes the home-buying decision a little more complicated. The old argument that you want to own instead of rent so that you can build equity doesn't exactly work when your monthly principal payments are going to offset a decline in prices. Just some food for thought.

Tuesday, September 21, 2010

Hong Kong Property Prices

We have previously discussed the property price bubble in mainland China as well as a similar bubble in Australia. Hong Kong, too, not surprisingly has been a center of quite a lot of speculative activity. There's a good post here about it: http://www.favstocks.com/hong-kong-bubble-hong-kong-residential-property-prices-july-2010/2024975/

I read a Bloomberg article today discussing whether or not it will be as bad as 1997. I really rather doubt that because while prices are approaching similar levels, incomes have grown notably in Hong Kong since then. However, there is little doubt that even with that income growth prices have still outstripped people's ability to afford them. This is all despite admirable attempts by the government to stop the bubble from building. 

On a related topic, the mainland Chinese government is rumored to be introducing a property tax in the fall. http://www.bloomberg.com/news/2010-09-21/china-may-unveil-property-tax-in-october-to-reign-home-prices-report-says.html A property tax similar to that in the U.S. does serve as a buffering mechanism to restrain house price bubbles for two reasons. One is that it adds a significant annual carrying cost so that you are dissuaded from sitting on property waiting for the right price. The other is that it cuts down on your expected rate of return and the tax is immediately capitalized into the house price. 

I will point out that states with high property taxes generally were spared from the housing bubble in this country, at least the most direct effects of it anyway. California and its peculiar property tax system actually encourage bubbles because house values are capped for property tax purposes at artificially low rates until they are sold. Depending on the rates China introduces, this will have a major effect on the housing market in China. Those sitting on investment properties that presently have no tenants will find the costs too great and be forced to sell while prices generally will take a hit. I think this is an interesting experiment on China's part to try to rein in a bubble before it reaches unmanageable proportions. However, it may be too late.

Sunday, September 19, 2010

DRIPs: Where to go for them

I've been a pretty big fan of Dividend Reinvestment Plans (DRIPs) over the years and something close to half of my invested assets are in them. For those who want to invest small amounts without having to deal with a broker, I really think these are a very good option because you can put in money in dollar rather than share denominations.

In terms of where to go for them, here are a few different websites of providers:

Shareowner Online (Wells Fargo): 


Investor Service Direct (BNY Mellon):


ADR.com (JP Morgan):




There are a few others out there, but these are the ones I would start with. There are some companies that seem to do it directly such as Procter and Gamble (PG): http://www.pg.com/en_US/investors/investing_in_pg/sip.shtml

I think these are fantastic programs, but keep an eye on the fee schedules when choosing how to do your automatic investments. If the plans charge a dollar per transaction and you put $25 in a month, that doesn't make much sense. You are paying 4% transaction costs then.

Funny Blast from the Past

So, I was going through some books of mine, and I found this one sitting in a bin from my move from my old apartment:

I think this was one my brother picked up around 2003 or so at a rummage sale for about $0.50. In truth, it's probably worth less than that, but it may surprise you to know that this book is not devoid of data and rational argumentation. It actually made a somewhat persuasive case and not all of it was nonsense (though most was). Rather, I think it was a case of where the author had already made up his mind of what he thought the markets were going to do and built his evidence around his prejudices.

Incidentally, this same author is projecting another Great Depression in the near future. Take that for what you will.

Thursday, September 16, 2010

So how are those "exploring new frontiers" stocks doing anyway?

I asked myself this question when I was walking home today, so I decided to take a look. For a reference, here is the link to the previous post: http://fmonitor.blogspot.com/2010/08/exploring-new-frontiers-five-stocks-ive.html On balance, I think fairly well. We discussed them here on August 8th, so here is the chart since then.

Of these, PVD is clearly the star, but XRTX has done well and SBS has beaten the S&P 500 marginally. PNR and NUS are lagging, though not severely. If you put equal weights into these five, you would be easily beating the market. Of course, that's only over the course of just over a month so who's to say this will continue, but there you have it.

All of these have been somewhat difficult to keep up on because they don't typically get financial news coverage and it is often hard to discern from press releases whether news surrounding a company is good or bad. That's a risk you take with the obscure names.

Early Indications of September Consumer Spending

I've gotten in the habit of looking at the advance indicators of consumer spending as it helps to get a picture anywhere between half a month and a full month before the actual data comes out.

In September so far things aren't looking that good. Auto sales are on pace to drop from August, which was down a little bit compared with July. http://www.dailyfinance.com/story/autos/after-strong-start-u-s-auto-sales-slow-in-september/19637006/

On store front, it looks like sales are flattish from August so far, but they aren't down either. There's enough of the month yet in play to decide the matter.

From the MBA purchase index it seems that home sales will be at these heavily reduced levels for a little while yet. With high inventory levels, another 5-7% drop in home prices nationally seems quite likely over the next year or two. Most of the professional forecasts (Moody's, Global Insight, etc) are calling for something in that range now after being more bullish in the earlier part of this year. Evidently they were distracted by some of the tax credit induced price supports.

This activity suggests tepid consumer spending for Q3, though it was actually a little better than many were fearing and the data do not suggest a double-dip recession.

Tuesday, September 14, 2010

Another Take on the "Bond Bubble"

Here's a somewhat more well supported take on the bond market from Angry Bear than what you'll see most places. His model suggests that bonds are properly valued at the moment and were actually somewhat cheap not that long ago. I haven't looked much into his model yet to see if there's something I disagree with in there, but given levels of GDP growth and inflation, it could well be that present bond prices aren't that overvalued.

I don't happen to buy into the thesis that bonds are a bubble in the same way that stocks were in 1999 or housing was in 2006. I think they are only modestly overvalued on an absolute basis, but they are very unattractive to stocks at the present time. Let me put it bluntly. Do you think that the total return of bonds, which will be the present yields at best considering prices are likely to drop as interest rates rise, will exceed that of stocks over the next five or ten years? Even after adjusting for the relevant risk premiums, stocks are quite a bit more attractive than bonds at the moment.

Monday, September 13, 2010

Flat Footed?

Steve was kind enough to point out two opportunities in the footwear sector that opened up last week while I was in the midst of a particularly brutal week of 10 and 11 hour days. I've had the chance to take a look at them this weekend and today, and I wanted to chime in.

These are specifically Crocs (CROX) and Skechers (SKX). While Crocs has taken a more recent and dramatic hit, Skechers interests me because it is down so much over a protracted period of time and because of its PE ratio of... 7. Before continuing, here are the charts:

Under most circumstances I am usually leery of charts like Skechers'. What seems to have happened in this case is that there is a wicked case of multiple compression. Apparently, the sales forecasts for a particular shoe (I know nothing of fashion so I won't even try) the market had built into the price were a little too much and the growth rate has come into something more reasonable. To be perfectly honest, you don't need very much of a growth rate at all to justify a 7 PE.

In a market that is valuing a great many stocks at criminally cheap PEs, single digit PEs shouldn't draw so much attention, but for a clearly growing company this gives me pause. There have been fashion related stocks in the past that seem to be getting very cheap, but then they are doing so for a reason. Chicos FAS (CHS) dropped about 50% in 2006 from $40 to $20 and saw a multiple compression from 40x earnings to about 17x earnings, which was a little cheap compared to the market at the time and its growth rate still seemed alright. It's at $9 now and trading at 13.7x earnings. That being said, Skechers seems particularly attractive and could actually see earnings drop as much as 30% without becoming unattractive. It's not often you can say that about a company.

As for Crocs, I have to be honest that I never understood the trendiness of their products to begin with so when they nearly went under a year and a half ago I wasn't shocked. They've come back in nearly Ford-ian fashion, perhaps better, and I have to be honest that I don't fully understand whether or not they are back in style. Earnings have recovered notably and their forecast reduction really wasn't that bad. The stock price hit I think reflected that traders had been continuously hiking estimates and when Crocs simply brought them back down to a reasonable level the stock had to come in.

Between the two of them, a small position in Skechers makes the most sense to me, but I will confess ignorance of fashion trends and that can be more than enough to doom you in this sector.

Saturday, September 11, 2010

Australian Politics

I just read a good article about Australian politics.

Squeaking to victory
Australia's Labor Party managed to cobble together enough independent lawmakers to earn the right to form a government. But after pulling in a disparate group of election winners, some doubted whether Prime Minister Julia Gillard could keep the minority government in office for a full term. Read results of Australia's election. 
It will be interesting to see how long the government lasts. The next regularly scheduled election is three years, but my bet is they don't last that long. As BQ has mentioned, Australia has its own real estate bubble going on, and when it breaks, my guess is so will the government. 

While the collapse of the government would cause some uncertainty, I would imagine that the Coalition would decisively win and be able to rule on their own. That should restore governmental stability and leave them with enough votes to get bills passed. Will the bills be any good? Who knows, but I think one thing Australia won't have to worry about is political indecisiveness. 

A September 11th Financial Retrospective

Shocking events such as September 11th usually have dramatic effects on the financial markets because financial markets are made up of individuals and if individuals suddenly, all at once, feel uneasy about the world, things can get ugly in a hurry. After the 9/11 terrorist attacks, the markets certainly reflected this.

Just as a little refresher, the first plane hit the WTC before the markets had opened and they were instantly shuttered. If one has been in that part of New York City, I am sure they can see why. It's uncomfortably close to the NYSE and American Stock Exchange. Leaving the markets open all day as the rest of the events unfolded could have led to a truly unfathomable sell off. With all of the rumors of as many as 40 planes high jacked, false reports of a bomb at the State Department, and everything else, we would have easily broken the 10% decline barrier that causes a one hour shut down at the NYSE and probably would have broken the 20% barrier as well. In fact, I think there would have been an outside chance at the 30% barrier as well. Rumor and fear were really out of control. Though I didn't have a brokerage account, I do have to say that watching the cascading collapse of the twin towers would have probably been enough to put in market sell orders.

Even though the markets were closed that Tuesday, and the next three days for that matter, time did not blunt the sell off much when the markets finally reopened on September 17th, 2001. While the 17th was certainly the worst day of that week, the rest of the week was certainly not exactly a walk in the farmer's market. By the close of business on Friday September 21st the Dow had dropped about 15%. The total U.S. market capitalization dropped nearly $2 trillion. At the end of the day, however, September 11th had relatively little economic impact. Bear in mind that the recession we were in at the time had started in March 2001. By November, it was over. Outside of the airlines and the hotels, very few companies had to cut their earnings forecasts due to 9/11. Some tech companies were still cutting their forecasts from the ever deflating technology bubble, but that's a different story altogether.

To be a bit more succinct, 9/11 had nearly squat all for economic impact outside of the financial market shock and even that was a very small effect in terms of a permanent impact. In fact, the disruption to air traffic had a very positive effect in reducing oil demand and therefore prices by nearly a third before they slowly started to crawl back. Further, and this is the more interesting part by far, were the opportunities created by the panic.

My favorite example is United Technologies (UTX), which is also one of the all time great stocks generally if you are interested in accumulating core positions. One of United Technologies' businesses is of course aircraft engines and of course if the airline industry was hurting they would buy fewer planes and therefore aircraft manufacturers would buy fewer engines. However, investors in their panic seemed to forget that United Technologies also has a large defense business that was bound to do quite well in an environment of increased defense expenditures. The results speak for themselves.

Bear in mind that this is from 9-10-2001 to 9-11-2006 so this does not show the gain from the bottom, but rather the gain from before 9/11. As you can see, UTX took an approximately 35% hit as a result of 9/11, which is far worse than the market as a whole, but that was quickly erased and then it went on a tear, which has seen it add another 80% to that rally beyond this chart. From the bottom it is up 220%, which is pretty damn good compared to an overall market that is up around 10% or so. The market in general, though it is hard to see here, recovered all of its post 9/11 losses within about six weeks or so and the Dow closed a full 1,000 points above its pre-9/11 levels by March of 2002. Then of course, the accounting scandals of that year, persistent slow economic growth, and fears of a double-dip recession sent the market far below its 9/21/2001 closing lows.

To conclude, whenever an upsetting event like a terrorist attack or natural disaster occurs, at some point your mind may perversely wonder "How will this affect my investments?". The answer is almost invariably that it will not affect your investments as much as the market would seem to indicate in its initial reactions and in those moments you can make a lot of money. Now, a genuine financial crisis like 2008, on the other hand, is quite a different story.

Tuesday, September 7, 2010

Europe Won't Stop Stalking Us

I was browsing Calculated Risk this morning as part of my normal morning crawl through financial websites (it actually relates to a portion of my work assignment so it isn't just leisure time for me) and found this very succinct breakdown of how the European debt crisis has not eased.

Obviously, the financial markets responded accordingly sending bonds and gold up while stocks declined. I guess now is as good a time as any to pull out my favorite little chart again:

Click to enlarge
So, as we can see here, there is a much greater reason to fear European contagion than Chinese contagion, at least from a financial sector standpoint. Though I don't have data on this, the really worrying thing is the amount of exposure that British and German banks have to the highly stressed countries. Perhaps more concerning is that the iron core of the EU, Germany, is probably not politically able to embark on further interventions. Angela Merkel's government is quite unpopular now (though so is nearly every incumbent government save Brazil's) and likely would fracture under the weight of another intervention. 

At this point, I think Jean Claude Trichet may want to reconsider his adherence to some fairly odd economic theories. He has placed far too much faith in what has been an anomalous economic performance out of Germany that has much more to do with little burps and belches of export demand than anything else. Domestic demand is flagging there as it is elsewhere in Europe. 

When viewing these sorts of crises, it's always hard to judge whether you are looking at Brazil in 1998, which bent but didn't break, or, say, Argentina in 2002. The telltale sign is to look for political instability in the afflicted countries and there we are seeing some twinges. If there is a cascade of government collapses then the rolling series of defaults long feared would seem likely. So far, it looks like that is under control, but it bears watching. 

Shell Shocked Into Stupidity

Steve was kind enough to forward me this Newsweek article while I was at work today and now I feel the need to share it. http://www.newsweek.com/2010/09/07/young-adults-invest-conservatively-post-recession.html

I have actually witnessed this among some in my age cohort (I just turned 24). I think I can speak fairly well on behalf of my generation when I say that we have not known a good investing climate. I mean, look at it:

That's the S&P500 over ten years and now financial advisors expect my generation, a very cynical and disillusioned lot to start with, to believe that things always do well "over the long term". I know people, and I won't name names, that honestly believe that the best thing you can do with your money is pile it ever higher into government bonds. They have been shell shocked by the grind of the financial version of The Somme into fairly morbid stupidity. Well, I suppose they are chasing performance since treasuries have absolutely butchered stocks over the last decade. However, I also remember after the last major bear market when a couple of my friends in high school told me that the only asset to invest in was "land", trying to evoke an air of nobility about their investments. How did that turn out?

I've been investing, with varying degrees of success, for this period and only this period. I've known nothing else but this horrible market, but it hasn't phased me because, if you are careful, there are winners among the carnage. Also, and this is much more important, it is important to realize that this last decade was somewhat anomalous for two major reasons: 1. The late 1990s bubble and 2. The housing bubble and the subsequent meltdown. Stocks came into the decade about, oh, 40% overvalued. The 1990s would have been a perfectly fine decade in absence of the last major run up, but it got out of hand for a number of reasons I am in the process of writing about for another post. Then of course we had the most serious financial crisis, well, ever since the Great Depression was actually more of a real economic contraction that caused a self-reinforcing financial crisis than the other way around, which is closer to what happened this time.

Admittedly, these sorts of events are not that uncommon in the context of financial market history. Indeed, bad decades (or similar intervals) seem to occur nearly one in every three for the period in which we have modern data. Is there any reason that this pattern seems to hold? There isn't some basic law of nature that dictates this, but it is probably simply a likely coincidence given the variety of market failures that can, do, and will occur.

What all of this means is that do not let past performance, whether bad or good, influence your current decisions too heavily. After a decade (the 1990s) in which stocks committed acts of utter brutality against bonds, it was a mistake to invest in stocks that had an effective earnings yield of 2.5% when bonds had a yield of over 6%. Similarly, right now it probably doesn't make much sense to buy treasuries which have a yield of 2.5% when stocks have an earnings yield of... about 6%. Wait, what? That's weird how that happens isn't it?

Now that we have that out of the way, time to move on to the most recent relapse of the European disaster.

Monday, September 6, 2010

Does Google Actually Care About Its Shareholders?

I found an article from back in July discussing Google's (GOOG) seeming lack of love for its shareholders. I think that this does bring up an interesting point which is that Google's management does seem a bit more interested in some of its more transformative projects than necessarily routinely providing a good return to shareholders. Say what you will about Apple (AAPL), but Steve Jobs never enters a product area without a very good idea how he's going to make money for Apple shareholders.

Google, on the other hand, has sprawled into a variety of areas that I am not sure have yielded the highest possible return on investment for investors. One of those areas is, of course, YouTube. We all love YouTube, but it is a bit of a free lunch as the advertising dollars don't even come close to covering the vast operating expenses. In total, YouTube lost something on the order of $450 million last year. Now, Google may argue that somehow owning YouTube has boosted its ad revenues by X% elsewhere and that has offset the cost. Even if that is true, and that's a big if, it still was not likely the best return on investment Google could have embarked upon at the time.

With Android, Google is winning the war against Apple with Android, which should be fantastic news for Google considering the growth of the smartphone market. However, I think this is a case of where Google management wanted to embark on a more transformative path than a lucrative one. It doesn't charge a license fee for Android, which it developed (and still develops) so it doesn't make money up front. Further, its own attempt at a phone flopped badly while Motorola (MOT) is resurrecting itself on the back on Google's labors.  In the end, I am still not convinced that Google will get more ad dollars through greater usage of its search engine than it would have if it had not entered the market. After all, I think most iPhone users probably use Google's search engine.

Then there are the other projects like when Google planned on giving San Francisco free Wi-Fi, its plans to provide ultra-fast internet to a variety of US cities, a free web browser (which is awesome by the way), and so on. You add this in with not paying a dividend to shareholders despite a monstrous cash pile and you do sit there and scratch your head a bit. Since publicly traded companies have a fiduciary responsibility to try (though most fail) to earn the maximum possible return for their shareholders, I have to question whether or not Google management actually acknowledges this responsibility.

The stock price performance over the past couple years reflects that as well:

There is multiple compression in there to be sure as profit growth, despite the above mentioned problems, has been quite solid. However, this multiple compression is not just a function of a bad overall stock market, but possibly also because investors may not believe that management can continually deliver how they have in the past due to these diversions.

Friday, September 3, 2010

What if China's Real Estate Market Does Pop: U.S. Outlook

On the heels of Alex's post on his on-the-street view of the Chinese real estate market, I wanted to provide a good sense of what the actual risks are. As you may have seen earlier, I don't buy into the double-dip recession hypothesis except if there is a large unforeseen shock. Now, as soon as I wrote that, a reader might have gone "AHHHHH!!!! They've said this all before!" Indeed it does sound awfully familiar. Indeed, some friends of mine may know that I thought the 2008 recession, which I admittedly called in 2007, would be shallow and long in the absence of a total freeze in credit markets. In truth, even short of Lehman, it appears that it would have been deep in any case. So, I guess to try to be better prepared it might help to examine what are the potential channels of a relapse.

The first one we might want to examine, because its effects set in the quickest, is on the banking side. I drew up this little table that showed bank risks by country as of Q1 2010. I am quite sure these haven't changed much since then.

In relation to the risks that our banks took in the real estate sector, the risk to China is small potatoes. Even in the event of a total calamity, maybe 30% of that would be written off. Spread among the various banks that lend to China, it's not a particularly big deal. Now, I put in Japan and Korea because it's possible that some of the large financial institutions there have also been providing credit to China. I can't find data on that because: 1. The relevant websites are in their native languages most often and 2. Disclosure in most other countries isn't as good as it is here. It's actually one of the reasons the U.S. has commanded lower risk premiums over the years, recent experiences notwithstanding.

A second channel some might point to is the U.S. Treasury market where China might sell off assets and repatriate money in the event of a major financial crisis. There is actually historical precedence for that where in World War I France and the UK repatriated assets from the U.S. and helped contribute to a rather nasty decline in equity markets here. The fear is that China would cause interest rates to spike prematurely, raising borrowing costs for corporations and governments alike and that the interest rate shock could completely unsettle financial markets. However, this is only really a problem on a short term rather than a long term basis as what can happen is that the Federal Reserve could step in and soak up the sales and slowly work that off over several months in order to keep markets orderly. There is no guarantee that the Fed would do this, but they could do this.

The third major channel is of course through exports. Now, U.S. exports to China are running at about an $80 billion annual rate or so. This is about .7% of GDP. Even a huge hit to these exports of, say, 40%, would not be enough to drive the U.S. into recession, even in our presently weakened state. I have said as much before. However, I did some more thinking on this and of course there are other spill overs. Other trading partners including Brazil and Australia buy decently large amounts of capital equipment including mining machines from the U.S. in order to extract raw materials to sell to China. Add up the $36 billion at an annual rate we sell to Brazil and the $14 billion at an annual rate we sell to Australia along with maybe another $30 billion to other large natural resource extractors and you get, well, around another China's worth of secondary effects. I haven't looked closely enough at the trade data with each of those countries to know how much of what we export is actually economically cyclical, but the odds are that it is quite a bit.

Even with all of this, it would not be a calamity, but it could be enough to grind growth to a complete halt for a time given how modest growth is right now at maybe 2% annualized in the third quarter. Luckily, China seems to be dragging this real estate cycle out long enough that a crisis might not occur until our growth is a little more self-sustaining. As for some other economies, anything Australian-related worries me. They have this potential pitfall as well as their own housing bubble. Brazil would suffer badly if China suddenly stopped importing so much iron ore among other things. The same holds for Peru and Chile and whatever commodity-export countries you might think of.

Now, the Chinese real estate market should give plenty of warning signs before a collapse in both residential and non-residential investment might occur. The first would be stagnation in prices followed by a pullback of some sort. As prices drop, expectations about future returns drop leading to cancellations of building projects and a slow down in new projects. This in turn leads to a drop in the imports of raw materials and machinery. All of that actually takes some time to manifest and you can spot it in advance if you are looking for it.

Another View on Interest Rates and PE Ratios

In the interest of fairness, here is a view saying that comparing interest rates and PE ratios is a useless exercise: http://www.marketwatch.com/story/are-stocks-really-undervalued-2010-09-03?dist=beforebell

I have several issues with the way the study was conducted as it seems a painfully simply regression analysis for a firm that specializes in it. What I found in my own research was that periods of a big positive spread between earnings yield and interest rates correlated very highly with periods before a major bull market and the inverse was also true. There was one period where this relationship broke down badly which was the 1990s, but that was the only one I could find.

I will do my own regression along the lines of the way they designed it and try to figure out how they came up with what they did because my knowledge of the data does not seem to support the notion here. Now, they used real rates of return against nominal comparisons of PE ratios and interest rates, whereas I kept everything in nominal terms.

Thursday, September 2, 2010

Chinese Real Estate: Inside Perspective

So this is a few months late, but I thought I should still add some to BQ's excellent posts about the Chinese real estate situation.

Summary: I think that Chinese residential real estate is in the middle of a huge bubble. When will it pop? That's the tough question.

So while traveling in China this past summer, here were some of the things I noticed that made me scream bubble.

1. Prices have skyrocketed. From talking to people, many places have gone up 250% in the past 5 years. While that doesn't guarantee a bubble, I would say that steep of a price rise coupled with a huge price/income ratio signals bubble.

2. Construction everywhere, but where are the people? The construction frenzy continues not only in Shanghai but to a smaller town (Chinese town = only a million people) about an hour outside by train. It seems that many places are being built up on anticipated spillover demand, not actual demand.

3. Expat money. One reason the bubble has gotten so big, and may even get bigger, is that expatriot Chinese are using the construction boom to pick up a place. Many of Tina's cousins have decided to buy a place for the week or two out of the year they plan on visiting China. However, I think expats are not a great way to support real estate because as the rest of the world's economy turns around, China's real estate looks comparatively like a worst investment. I think that money can dry up quickly.

4. IPO's. The Agricultural Bank of China (ABC) had the world's largest IPO this summer. However, I read in a Chinese newspaper that when ABC's directors met with investors, one ABC executive fell asleep while another kept laughing nervously as a response to any questions. So it sure looks like an unprofessionally run bank that is just trying to cash in.

5. The feeling that this is different. Everyone I talked to recognized that prices were ridiculous, but also said that they can't collapse because first, rural Chinese are moving to the cities and second, the government can't let them collapse. I think the first argument is pretty weak since the rural Chinese aren't that wealthy, so I can't see how they play that significant of a role in the real estate demand. The second argument is downright scary. This implies that people are taking significant risks that they would not take if they thought the government wouldn't step in. Can the Chinese government prop up the real estate forever? Not a chance. Can they prop it up for a while? Sure, but at what cost? I'm sure BQ can illuminate more about the danger of a government trying to artificially inflate prices.

So what will the impact be on us? I really don't know, hopefully BQ can illuminate more with numbers, but it seems like the direct expose to Chinese real estate by US banks is minimal. There will be some indirect damage since many US banks did by into the ABC IPO and other Chinese banks. The bigger impact will be what the collapse does to the overall Chinese economy and that spillover effect.

Wednesday, September 1, 2010

Another Look at August Consumer Spending

Now that we have auto sales for August in and all of the weekly retail sales reports as well, let's revisit what August held for consumer spending.

Auto sales, which looked to be decent as recently as the 20th, actually came in slightly below July's level, though I will emphasize "slightly" with the change being -0.5%. Still, we have not seen much lift in car sales, which is kind of depressing given that they still are abysmally low. Chain store sales on the other hand seem to have been relatively strong following the weekly retail sales reports this month. Redbook indicates a sales pace that is a full 1.0% above July on a seasonally adjusted basis. ICSC is indicating a similar year on year growth rate of 2.8% vs Redbook's 3.0%, though no indication of whether there was an increase month to month. We'll actually get a sense of that in about ten hours or so when the retailers discuss their August sales.

Of course, home sales were fairly weak and probably didn't increase much from July from the look of things. As we have mentioned previously, the plunge in sales and high inventories (at least relative to these sale rates) will bring down prices. Whether those lower prices will bring down consumer spending with them remains to be seen.