Introduction

Although I read and collect information and ideas every day, whenever the day comes each month when I actually have to start writing this report, the words of Gene Fowler (an extremely successful screenplay, sports, and humorous writer) come to mind: “Writing is easy. All you do is stare at a blank sheet of paper until drops of blood form on your forehead.”

On these occasions, I then usually turn to works of science, politics, history, or philosophy in the hope of calming down and finding some inspiration. Since so many investors look to investment advisers such as myself, whom they often call “gurus”, for guidance on the future of the markets, I think it is appropriate to remind my readers of these words of Lao Tzu (the sixth-century Chinese sage): “Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.”

I have mentioned this because I was recently invited by my friend Manish Chokhani, of Enam Financial Consultants in Mumbai (the most successful investment bank in India), to give a presentation. The founder of the company, Vallabh Bhanshali, introduced me by saying that his staff consider me to be a hero for having correctly predicted the bull market in Indian equities in 2002, and for having called in 2006 for the 30% May/June sell-off. I felt deeply embarrassed by this, as I know only too well that I have made just as many, or even more, poor and erroneous market calls as correct ones in the course of my life, and not only about economics and asset markets but also about people… Moreover, I know people who are far more knowledgeable about the financial markets than I am – people such as Henry Kaufman and Peter L. Bernstein – who focus on presenting well-researched facts in their excellent papers, publications, and presentations, and refrain from making predictions.

In fact, addressing large audiences makes me feel uncomfortable – not because of the size of the audience, but because, as a contrarian, it is not desirable for my views to be popular and because assets that I consider will perform well in the future seldom attract large crowds. Two friends of mine, Jon Thorn and John Shrimpton, who manage, respectively, the India Capital Fund and the Vietnamese Dragon Fund, used to have tiny audiences when they presented at investors’ conferences. But as their markets more than doubled in size, so did their audiences.

In 1981, I was invited to speak about bonds at a gold conference that had attracted over 500 participants. Just one person came to my presentation. (September 1981 saw the end of the bond bear market, which had begun in 1942.) A small audience can sometimes be distressing for a speaker, but at such times they would be wise to remember Victor Borge, a Danish pianist with a sharp mind and humorous bent, who fled to the United States in 1940 and made a name for himself with his brilliant blend of musicianship and humour. One evening, in Flint, Michigan, Borge performed to a sparse audience. The sight of so many empty seats might have discouraged the average performer, but the witty Borge looked out over the audience and exclaimed: “Flint must be an extremely wealthy town. I see that each of you bought two or three seats.” (Lateral thinking at its best!)

As an investor looking for guidance from newsletters, blogs, financial publications, and conferences, I would also be mindful of Ralph Waldo Emerson’s words: “Do not go where the path may lead; go instead where there is no path and leave a trail.” Unfortunately, in today’s high-liquidity driven global investment environment, I find it hard to identify an asset class “where there is no path”. There are far too many smart – and not so smart – treasure hunters who have bid up every imaginable investment class right around the world. It is only in the most unusual places that I can find true value (often, however, in assets that are difficult to invest in), as opposed to relative values, which certainly do exist. The problem for investors is that, as the German theologian Dietrich Bonhoeffer wrote, “If you board the wrong train, it is no use running along the corridor in the other direction.” (Bonhoeffer opposed Nazism and was executed in prison for his involvement in a plot to overthrow Hitler.)

I mention this because it will become increasingly important for investors not only to decide which asset class train they want to board, but also, and even more importantly, whether they want to board any of the asset trains. If we look at the economic and financial history of capitalism, we can see that over periods of five to ten years there were always some assets that performed well. But there were times, such as in the early 1930s and the 1970s, when very few assets appreciated. Gold and gold shares performed well in the early 1930s. And in the 1970s, precious metals, and energy and energy-related shares, appreciated dramatically. But what were the chances that, in 1929, an investor would have had all his assets in gold, or, in the 1970s, in energy and precious metals-related investments? Moreover, in both cases, these investments had to be liquidated at some point because, as is always the case, “over-staying” eventually leads to huge losses. And this is where I see the biggest problem in the current investment environment. At the beginning of a bull market in an asset class, there are very few participants. But by the tail end of the boom the vast majority of market participants have become convinced that the boom will last forever or that a greater fool will soon emerge and take them out at a higher price. (This is likely to be the thinking among private equity fund managers.) So, in every boom, the majority of investors eventually get caught when the investment bubble bursts, as was the case in 2000 with high-tech stocks and in 2006 with US homes.

In last month’s report, entitled “When Too Many Investors Think Alike, Nobody is Thinking”, I pointed out that a peculiar feature of the bull market in asset prices since 2002 has been that all asset prices around the world have appreciated in concert as a result of highly expansionary monetary policies, which has led to excessive credit growth and a credit bubble of historic proportions. Therefore, if my theory of slower credit growth in future holds, it is conceivable that, for a while at least, all asset markets (with the exception of bonds and cash) could come under pressure, albeit with different intensities.

In fact, asset markets would come under pressure even if credit growth continued at the present rate and didn’t accelerate. In this instance, investors would be better off not boarding any investment train at all and, instead, staying at the station loaded up with cash. (However, they would still have to decide what kind of cash to hold.)

An Attempt to Pierce Through the Investment Mist

I have mentioned in the past that the first signs of credit tightening would be visible in the performance of US brokerage stocks. Recent pronounced weakness not only of brokerage shares, but also of other financial stocks and, in particular, sub-prime lenders, would seem to confirm that the “irreparable cracks in the financial system”, about which we wrote in the January issue of this report, are now spreading. These cracks are now causing some “illiquidity”, not only in the household sector but elsewhere in the system as well. First, it is important to understand that mortgage debt has begun to grow at a slower pace largely because home prices are no longer appreciating. The growth in the mortgage market was about equal to nominal GDP growth between 1980 and 2000. But, in the 2000 to 2006 period, a massive breakout from the trend occurred and, combined with a decline in the saving rate, drove consumption and GDP growth. But, as home prices began to decline in 2006, and as problems in the subprime lending market became evident, lending standards were tightened to their highest level in 15 years. Declining home prices and tighter lending standards brought about a slowdown not only in mortgage debt growth but also in overall debt growth. Mortgage debt, which grew at an annual rate of 10.2% in the second quarter of 2006, declined to an annual growth rate of 8.6% in the third quarter and to 6.4% in the fourth quarter. It is likely that mortgage debt growth slowed down further in the first quarter of 2007, and will decline even more in the second quarter given the problems in the sub-prime lending industry and the tight lending standards.

In the meantime, household debt growth in the United States has declined from a peak of 11.9% in the third quarter of 2005 to 6.6% annual rate in the fourth quarter of 2006. According to David Rosenberg, the fourth-quarter 2006 annual credit growth was the slowest since the third quarter of 1998 and the sixth consecutive quarterly deceleration, “which hasn’t happened since 1956″ (emphasis added). Now, ceteris paribus, this significant slowdown in mortgage and household debt accumulation would have already brought about a significant slowdown, or even a decline, in US consumption. However, because of the stock market rally in the fourth quarter of 2006, equity wealth increased by 4.2%, or an annual rate of 18%.

Moreover, as David Rosenberg notes, “just as households are beginning to curb their appetite for debt, the once-dormant corporate sector stepped up its borrowing sharply in Q4 (M&A related perhaps?). Net debt raised by the nonfinancial corporate sector steamed ahead at a 10.9% annual rate in Q4, almost double the Q3 pace (of 5.9% annualized) and the strongest pickup in seven years. You have to go all the way back to the cashburn era of 2000 Q2 to see the last time that the corporate sector outdid the household sector in terms of debt buildup.” And as David Rosenberg correctly suspects, corporate borrowings have been rising along with M&A activity. But corporate borrowings are far smaller than household debt; therefore, while corporate debt growth has increased by around US$100 billion since the second quarter of 2006, household borrowing has grown since then by around US$300 billion. (Note also how, in the late 1990s, debt growth took off.)

Now, this deterioration in household debt growth hasn’t yet led to a consumer spending decline; but, very clearly, retail sales are now growing more slowly. Continuous consumption growth was therefore driven less by household debt growth in the fourth quarter of last year and the first quarter of this year, than by the continuation of an increase in household wealth and the selling of US equities by the household sector. But herein lies the problem. If declining home prices are now joined by equity prices that are either declining or no longer rising, it will only be a matter of time before consumer confidence declines and the consumer either slows down their spending further or stops spending altogether.

Slower consumption growth, as a result of tighter lending standards and flat or declining equity prices, should have the following consequences. The US trade and current account deficit will no longer expand at an accelerating rate. This should lead to a relative tightening of global liquidity, which would likely be unfavourable for asset prices but could temporarily strengthen the US dollar and even more so the Yen.

The full extent of the sub-prime lending problems isn’t known. However, since at least 12% of the mortgage market – whose total size is over US$1.2 trillion – is comprised of sub-prime loans, the fall-out could be considerably worse than expected. This certainly seems to be indicated by the recent poor performance of banking stocks and, as indicated above, brokerage shares. My friend Gerard Minack of Morgan Stanley recently published a figure showing how financial sector earnings have exploded in recent years. Figure 12 depicts earnings growth for the financial and nonfinancial sectors indexed to a common base (1990 = 100).

As can be seen, the financial sector’s earnings rose 14-fold since 1990 to an annualised US$251 billion, whereas the rest of corporate earnings experienced only a fourfold increase, to US$636 billion. I have mentioned in earlier reports that if we were to include in the financial sector’s earnings financial profits from speculating in all kinds of derivatives and financial products by industrial and multinational companies, the profit contribution from financial earnings to S&P 500 total earnings would be more like 45%. Also, the recent contribution to profit growth would amount to around 70%. Therefore, I suppose that if asset markets failed to appreciate further, financial earnings would begin to decline and likely pressure S&P 500 earnings. (Aside from the financial sector, the energy and material sectors have in recent years also boosted S&P earnings. Never before have energy and financials contributed so much to the S&P profit pool.)

In the past, poor performance of financial stocks has always been an unfavourable indicator for the entire stock market. In an economy that has become addicted to credit growth, this should be even more so! The other point to remember is that if corporate profits no longer expand, the ammunition used by the corporate sector to take over other companies and to buy back their own shares is likely to diminish. Last year, a record US$548 billion worth of shares were retired by corporations buying back their own shares and by acquisition-minded private equity funds. Any reduction of this activity in 2007, when simultaneously the increasingly “illiquid” household sector is likely to diminish its equity purchases further, is going to have an unfavourable impact on the stock market. I may add that, sooner or later, private equity funds will place the acquired companies back on the stock market and so increase the supply of equities through high IPO activity.

If the assumption is correct that global liquidity is tightening – at least relatively – as a result of a stagnating US trade and current account deficit, the asset markets that benefited the most from surplus liquidity should come under some pressure. I am thinking here in particular of the extended emerging stock markets, which in this scenario could be vulnerable to corrections of between 20% and 40%. In turn, a decline in these peripheral markets should have an impact on Japan and, in particular, on the Yen.

Regards,
Marc Faber, PhD

April 16, 2007

“Relax, the Over-all Market Probably Won’t Tank” was originally featured on Whiskey and Gunpowder

The answer comes from the San Francisco Fed in an article entitled, “Interest Rates, Carry Trades, and Exchange Rate Movements”:

“What is the carry trade?

“In the most common version of this strategy, an investor borrows a given amount in a low-interest-rate currency (the ‘funding’ currency), converts the funds into a high-interest-rate currency (the ‘target’ currency), and lends the resulting amount in the target currency at the higher interest rate…

“According to economic theory, an investment strategy based on exploiting differences in interest rates across countries should yield no predictable profits. Consider two countries, one with a high interest rate, and the other with a low interest rate. According to another equilibrium condition of international financial markets called the ‘uncovered interest parity,’ the difference in interest rates between the two countries simply reflects the rate at which investors expect the high-interest-rate currency to depreciate against the low-interest-rate currency. When this depreciation occurs, investors who borrowed a given amount in the low-interest rate currency and then lent it in the high-interest rate currency will find that their return is worth less. The uncovered interest parity condition implies, indeed, that investors should expect to receive no profits, as they should expect the return from lending in the high-interest-rate currency to be worth ultimately as much as the cost of borrowing in the low-interest-rate currency.

“In practice, however, investors in international financial markets do seem able to make profits through such strategies…

“Empirical evidence shows that currencies that are at a forward premium and that, correspondingly, have a low interest rate, actually tend, on average, to depreciate, not appreciate, as the theory of interest parity conditions predicts…Similarly, currencies that are at a forward discount and that, correspondingly, have a high interest rate, tend, on average, to appreciate, not depreciate. This anomaly, then, implies that an investor who enters a carry trade is quite likely to make predictable profits from two sources: the interest rate differential between two currencies and the appreciation of the high-interest rate currency that was originally bought at a forward discount.”

Referring back to the COT numbers on the yen from Part I…they might seem huge. After all, $13,212,986,904 bet on shorting yen futures sure looks like a big number, but in all likelihood is peanuts in the grand scheme of things. Expressed as $13.2 billion, it seems much smaller. Please consider Brad Setser’s excellent article, “A Trillion Dollars Gets My Attention, Whether It Comes From the PBoC or the Yen Carry Trade”:

“Tim Lee, of Pi Economics, reckons as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply (making the trade unprofitable), there could be hell to pay in the markets…

“I suspect Gillian Tett would be far better positioned to guess the actual size of the yen carry trade than most. Her excellent FT article spells out the various ways cheap yen have influenced global markets — and not just the obvious ones.

“Just how large the carry trade is, nobody really knows… But whatever the precise number, what is clear is that carry trades have been fueling the dash into risky assets in the past couple of years.

“After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5% a year, apply a bit of leverage and — hey, presto — produce returns of 20%, or more. Conversely, if an investment bank wants to create a collateralized debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books — funded by ultra-cheap yen. The yen has thus been tantamount to the ATM of the global credit world — spewing out (almost) free cash.

“There is nothing like borrowing in a depreciating currency to buy the equity tranche of a CDO in a world where there are virtually no defaults. No wonder investment banks have been so profitable.

“Of course, the biggest carry trader of them all is the Japanese government. It borrowed a lot of yen to buy something that yielded a bit under 5% a few years back…

“That trade has paid off. Big Time. The MoF borrowed in depreciating yen to buy appreciating dollars — and got a bit of carry in the process. And the MoF did it on a truly enormous scale.

“A private investor might even want to start to take some profits…

“Bottom line: A ton of people — the Japanese government and Japanese ‘real money,’ as well as the leveraged community — are short yen and long higher carry currencies at a time when the yen is very, very weak by most historical standards.”

In September 2006, MarketThoughts.com had an interesting article called “The Yen Carry Trade Revisited”:

“The second great yen carry trade began in the summer of 1995 and it did not end until October 1998 — when the yen ended its decline by rising 15% in a week…

“As for the current yen carry trade, there is little evidence to believe that much of the borrowed yen went into commodity speculation — as the decline of commodity prices in the last four months has generally not led to a higher yen. More likely, the typical profile of the latest yen carry trade participant is as follows:

“1. A speculator who borrows or shorts yen and use the money to invest in a higher-yielding asset (usually government bonds or CDs) in the U.S., U.K., or countries in the euro zone. The days of using this money to invest in higher-yielding countries in ‘peripheral’ developed countries like Iceland and New Zealand has definitely ended — given the crash in both of these currencies earlier this year.

“2. A Japanese investor (e.g., a pension fund, a life insurer, or an individual investor) who converts his money from yen to U.S. dollars (or the euro or the pound, etc.) in order to invest in Treasuries or overseas real estate. Note that this position is usually unhedged — which again puts further pressure on the yen.

“Quoting the IMF’s ‘Financial Stability Report’:

“‘The evidence that Japanese domestic investors conducted a form of the carry trade by seeking higher returns overseas is quite strong. Domestic institutions, such as life insurers, effectively engaged in the carry trade by purchasing foreign bonds to support yen-denominated liabilities, often on an unhedged basis. Net purchases of foreign bonds by life insurers totaled 848 billion yen ($7.4 billion) in 2005. Individual investors — particularly wealthier retired households — shifted a share of wealth away from bank deposits or other low-yielding yen investments, toward foreign bonds or investment trusts explicitly tied to foreign bonds (see the first figure). At its peak in late 2005, the money flowing into foreign bond funds exceeded 5 trillion yen over the trailing 12-month period, equivalent to about 1% of GDP’…

“Positioning on yen futures contracts also points to the existence of an offshore yen carry trade. Data from the Chicago Mercantile Exchange show noncommercial traders (predominantly financial players) moving from net long to net short yen positions in early 2005, and staying net short until the end of April 2006… [Mish Note: Speculators are hugely short yen futures again, as discussed above.]

“So the $64 trillion question is this: When will the yen carry trade end? On a purchasing power parity basis, the yen is undervalued against the U.S. dollar, but massively undervalued against the euro. That being said, things can always get more extreme before reversing — especially when it comes to the financial markets. Drawing a tentative uptrend line from the previous lows in the yen in early 1990, October 1998, and early 2002, one gets a target range of approximately US$0.78-0.82 (for every 100 yen) before we see the yen bottoming. But in all likelihood, it will need some kind of trigger. Just what is that trigger? I will discuss more about this as we approach the US$0.78-0.82 range and my preferred time frame (later this year), but for now, I am guessing lower-than-expected economic growth in Western Europe as the revision of the German VAT comes into play, starting Jan. 1, 2007. Historically, a goods and services tax has always meant a stronger-than-expected economic slowdown, and the German economy will be no different — despite the prevalent optimism among the German government at this point.”

So now we have Japanese life insurers speculating in the carry trade. Isn’t that special? One possible answer to the “$64 trillion question” (When will the yen carry trade end?) is that these things always seem to go on much longer and get more insane than any rational person deems likely. Such thinking suggests a possibility that the trendline break in the yen (as noted in Part I and repeated below) is a real one. Those following along carefully will note that is the opposite of what I suggested in Part I in reference to the COT data (i.e., an unwinding of the futures positions is dollar negative on balance).

Yen/U.S. Dollar (Monthly)

Fundamentals

• All fiat currencies eventually head to zero. The only difference is the length of time it takes to get there
• Gold has never gone to zero, and barring a Star Trek-like replication device or nanotechnology that can easily combine atoms to make elements, gold is not likely to head to zero, either
• In the meantime, the biggest factors that determine relative worth of currencies seem to be interest rate differentials, expansion of money and credit, and foreign direct investment. The much ballyhooed trade deficit is far down the list
• When it comes to the yen, the interest rate differential between Japan and the U.S. or Japan and Great Britain is substantial
• Japan is also sitting on a national debt of 150% of GDP. What that will do to interest payments if rates rise rapidly should be obvious. The implication is Japan may have to raise taxes substantially smack in the face of poor demographics (shrinking population). Japan has lots of reasons to resist hiking rates. That is yen negative
• Europe has demographic problems of its own. Europe also has a very rapid expansion of M3, but a much lower interest rate than the U.S’s. That is euro negative versus the U.S. dollar
• Great Britain has a housing bubble of its own and will undoubtedly burst at some point. This should put pressure on the pound, as expected rate hikes in the U.K. may not occur.

Everyone has a tendency to look at problems in the U.S. in isolation. As you can see, the issues are both many and complex. There are a lot more to currencies than the one-sided view often heard that “The U.S. dollar sucks.” This post is an attempt to look at things from as many angles as possible.

From a purely technical standpoint, I would have to suggest “Trust the trendline breaks on the charts.” From the standpoint that things almost always get crazier than anyone thinks, I am inclined to believe the yen is likely to sink further and then whipsaw massively. I suggested this quite some time ago and so far have been correct. From the explosive potential of the unwinding of the carry trade, one should be watching those charts carefully.

From a political standpoint, I am rather unimpressed with Paulson even as others seem to be going gaga just because he is “watching very, very carefully.” From the standpoint of the U.S. dollar in and of itself, things do not seem as bad on many standpoints as most seem to think, especially in relation to the Euro. Ultimately, however, the fate of the dollar may depend on the timing, magnitude, and swiftness of the unwinding of the carry trade, and from what level that unwinding occurs. Taking quick action should something go wrong with whatever you are doing (in whatever direction you are doing it) seems like the best advice at this juncture given that the situation is potentially explosive in both directions.

Regards,
Mike Shedlock ~ “Mish”

February 13, 2007

Focus on Currencies, Part II was originally featured on Whiskey and Gunpowder