Friday, May 26, 2006


Market Map I: A Galactic Overview.

This is a general post, but I hope to have a more detailed analysis ready at the end of the holiday weekend. Still, there should be some helpful ideas here. Finance is a kind of hydraulics. Asset prices are a restless ocean, rising here and falling there. Over the long arc of human history, the ocean has risen, reflecting the capacity of the creative mind to generate wealth, whether it be in the form of transistors or improved methods of child rearing. Over shorter intervals, asset prices have fallen or even vaporized. Wealth is the reality, and money merely its measure. Gaps between wealth and money represent speculation. Understanding the size and direction of the gap is how one makes money through investment. Successful investing is a matter of predicting the flows of capital. While timing markets is essentially impossible, it is possible to predict with reasonable certainty when markets have passed tops or bottoms. Not always. Alan Greenspan was right that the market was irrationally exuberant (i.e., overpriced) in 1996, but if one sold US equities then, one missed out on the best days of the Clinton stock boom. And there are surprising gaps in knowledge that can be exploited. Everyone knows about small-caps. The big investment houses don't follow them. Suppose a company starts up in your area. You like the service and know some of the people who work there. They tell you that things are on the up-and-up. You have inside information that can make you money. But there are other areas that can be exploited. One of my favorite is making money off of hissy fits pitched by the Rattlesnake Republicans. People of any political bent who let ideology-- as opposed to moral principle-- interfere with making money are asking to be made poorer, and should be obliged. As noted below, S&P apparently discounts markets in developing countries with a significant bias against left-wing governments. Yet it's well known from the US experience that moderate to left-of-center governments tend produce strong economic growth. That growth leads to demand-led rising markets that outperform those produced by right-wing governments, which usually follow the loot-and-scoot model of the Dubyans. So, S&P's self-imposed stupidity, i.e. its ideological bias, creates an information gap to be exploited. So, what is going on in the market now? Where is the money moving? And most important, where will it move? A good summary is this: In short, prices have gone up for several key items: credit, foreign currency, housing, and the fossil fuels that are a basic cost for virtually every home and business. Now, often times high prices can mean high short-term profits. It certainly works that way in the oil industry. But high prices also dampen consumer demand, often leading to recession. Furthermore, as Brad Setser says, "the fall in US [Foreign Direct Investment] stemmed from the Homeland Investment Act, a one-off tax break that encouraged US firms to bring funds home, not a sustained reduction in the desire of US firms to invest abroad. The implication: the US will need to place a lot more debt abroad in 2006 than in 2005." Also: [P]rivate flows from emerging economies are NOT financing the US deficit So: a weak dollar should be a given. 1. The flow into US housing is slowing, with home prices due for a correction, perhaps by as much as 40-50% in frothy markets. One can predict that stocks that depend on new housing construction and furnishing will weaken and that growth will decline as a result of less construction. 2. Stock prices for commodities of all kinds, even gold, have been hammered. This contradicts the inflation story (although gold stocks may decline somewhat in a bear market, even if their profits are rising). 3. Foreign stocks have been hammered, so gravely that Indian companies faced a liquidity crisis, resolved at least temporarily. This contradicts the weak dollar story. 4. Are interest rates headed sharply up, as one would expect in the case of inflation? 5. Are countries (other than the US) cooking the books? How bad is US book cooking? 6. How do calculations about vulnerabilities to natural disaster or war enter into this? One reason the US is a preferred investment destination is because it is less vulnerable to earthquakes than crowded Japan, less vulnerable to storms than Hong Kong or Singapore, less likely to be invaded than Taiwan. 7. To what extent do domestic political considerations play into this? There has been speculation that the departure of John Snow from Treasury could also be a cause of the recent market turbulence. Personally, I doubt anyone will notice when he's gone. I have suggested that the recent selloff might be related to a sense that the Bush presidency is ending, perhaps triggered by news of a (so far unannounced) Rove indictment. 8. Most important, what will the pathway of crisis/recovery be? The investor who guesses the path by which crisis will occur and by which recovery will happen will make money all the way, while if one guesses the path wrong, one will lose money all the way, even if they know the outcome. There is a lot of interesting reading to do, much assigned by Brad Setser: Bill Gross of Pimco: Higher inflation, higher personal and corporate taxes, and a lower dollar point U.S. and global investors away from U.S. assets and toward more competitive economies less burdened by health and pension liabilities – those personified by higher savings rates and investment as a percentage of GDP. Need I say more than to sell U.S. assets and buy Asian ones denominated in their local currencies Jean-Philippe Cotis of OECD[Assuming no further oil shocks,] the risks surrounding this scenario have increased as regards current account imbalances, long-term interest rates and house prices, while the inflation and activity outlook could be significantly affected by abrupt changes in oil and commodity prices. ... in 2007, Germany’s surplus would approach 4½ per cent of GDP and Spain’s deficit 10%. ...current account surpluses in China and Japan headed for 5½ to 6% of GDP in 2007, while the US deficit would exceed 7½ per cent. Think of two families, each earning $50,000. One of them is putting $3,500 per year into an IRA. The other is charging $3,500 per year on the credit card and saving nothing. That's a fair comparison of the US vs. Japan. Brad Setser: makes an interesting point: do purchasers generally stay in equities denominated in their own currency, or do they actually hedge for currency based on their choice of investments? He says: Best I can tell, though, those fleeing emerging economies for the safety of the US are largely US and other dollar based investors – not the citizens of emerging economies. Those who borrowed dollars to buy emerging market risk have a particular need for dollars. They are in a slightly different position that say investors in emerging economies who have in the past looked to the dollar as an alternative to their own shaky currencies. Like some others, I doubt that the unwinding of positions in emerging economies that originated in the US can provide an enduring base of support for the dollar...The interesting question – at least for me – is what happens once the dash for safety ends. Where does the money that got out go? And where does the oil money that was chasing yield in emerging economies go? Home? To the US? Or to the Euro? There are two basic storylines here: either Wile E. (for Economy) Coyote crashes into the canyon below, or he makes it successfully in his mad dash from mesa top to mesa top. Which is right depends on whether one believes that asset values are rising, despite war, deficits, and so on or that the books are being cooked. But within these larger stories, there are subplots. I think it may be possible to disentangle which of these subplots explains recent market moves, and that will be the topic of the next post.
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