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May 15, 2006

10 Bellwethers Why Caution is Not Irrational
by Wilfred Hahn

"If something cannot go on forever, it will stop." -- Herbert Stein, Economist

We see at least 10 deadly fallacies and classic bellwethers of irrationality currently impinging upon global financial markets. We will list them.

Why? It is a quirk of market cycles that money managers and investors are penalized for their sensibilities at certain key times...either during periods of great fear or rampant bullishness and speculation.

We are again experiencing one of those periods where we are left grasping for reason. Seemingly, all theoretical causality is removed from financial markets and money again is growing on trees.

Therefore, given that we identify strong reasons for cautious portfolio policy at this time, the onus is on us to prove that we are not irrational.

Bubble Symptoms

Every "bubble environment" breeds self-affirming fallacies that are widely swallowed as received fact -- eventually. As a result, in time, a sense of invincibility sets in. Before long, no one can imagine anything that might stop the good times. Even developments that have proven 100% deadly in past history -- for example, rising interest rates -- are supremely regarded as eminently surmountable. New ideas are advanced that requires classical theories and the laws of gravity to be temporarily suspended.

Not to be forgotten is an attendant side-effect of this type of environment. As financial assets become more expensive, the price of integrity and rationality also shoots up. Having too much of either will cost you big ... especially, if you fight the irrationality too early. It happened in Japan in the mid-1980s, globally in 1987, the Asian rim in 1992, again worldwide during 1999- 2000.

Is 2006 another one of those times?

One of the distinct hallmarks of such an era is that very few can see any developments that might ever again undermine buoyant markets. That symptom is clearly evident now.

With economic growth apparently rebounding in the US -- back to a rip-roaring 4.8% annualized rate in the first quarter -- and equities experiencing blistering returns in many markets around the globe year-todate, the idea that good times will continue is considered unassailable.

And why not? Despite what everyone thought were the surefire negatives of rising interest rates, energy prices, a waning housing market, and the most parlous household savings rates in history, North American consumers remain unbowed ... even if underwater.

And, neither unprecedented global savings imbalances, overheated economies, massive monetary excesses, rising inflation and interest rates ... nothing ... has been problematic for financial nirvana to this point. Therefore, it only seems reasonable to believe that these factors also could not merit any reason for caution.

So, what is left to possibly blame for any bad times? Only an Avian flu pandemic, terrorist activities or, thanks to Iran, destabilizing geopolitics. Quite frankly, we've stopped counting the number of rosy strategy reports that have represented the "fate of the gods" as the only threat to their central "bullish" investment case. Even the IMF has chimed in on this hedging theme in its latest mid-year outlook.

Stories From the Frontline

Another symptom of irrational times is the rise of the Marketing Department. Allow us to recall a few memories from past bubble environments. These stories will convey our sense of the current investment environment better than pages of theoretical analysis and economic theorems.

Everybody in the investment industry understands that what sells best is that which sells. Therefore, the sure gimmick to boost sales of investment services or products, is to come up with marketing pitches and credible experts that support the lusty bent of the times ... in other words, anything that feeds the fire of what sells.

Essentially, that's exactly what some large financial institutions do to achieve business growth. It works most effectively to have a few well-paid economists and analysts on staff who are especially creative when it comes to new "designer" theories.

The best of them can turn any pig-skinned statistic into a silk purse ... even portray downright evil developments for good. For example, fobbing off rampant overconsumption on the vicissitudes of irresponsible foreign over-savers sort of falls in this latter category. Apologies, if we might be sounding a bit irreverent. But wait, the facts will bear us out.

Working in such a climate, it gets real prickly if you are a strategist leaning against a "bubble" market. If so, you had better be right ... and quickly. To risk a month of underperformance with such a cautionary stance can be more painful to you than 12 months of your client's investment losses. Why?

You will be sure to meet the wrath of the Marketing Department. It wouldn't matter a whit if you have very sensible reasons for your position or that your views might actually align with client interests -- i.e. preserving their capital from hugely underpriced risk. I recall a few such encounters.

When the Marketing Department Rules

As a Director of Research for a major North American "wire house" brokerage, I was read the riot act by the head of the marketing department and their sundry sidekicks of "product managers." As market strategist, I had been bearish since April of that year. Yet, stock markets charged into one more up-leg over the summer months, even as bonds markets tanked. By September, the marketing people had enough.

Summoning me to a meeting, they pronounced that what the brokers want to hear "is a positive story" and that my current market policies were not suitable "for what we need to market." What did I think of that? Well, thank goodness I didn't buckle. What happened in October 1987 a month later made history. Admittedly, the whole experience wasn't much fun. And in no way, did I anticipate a crash of the magnitude that occurred. But, as the saying goes, it was a dirty job, and somebody had to do it ... though suffering the wrath of the Marketing Department.

It was not an unusual situation. A tragic aspect of that time and others like it, is that many strategists actually do capitulate to the Marketing Department. The contagious spirit of "easy money," the fear of losing a lucrative job and appearing as a totally irrational misfit, causes more than a few to lump logic and reason.

Another time I was excoriated by the Marketing Department, was during a stint serving as the Chairman of an offshore global mutual fund company. At a quarterly business meeting in early 1999, the meeting was lynched by a number of sales and business heads. They were very perceptive types. They had correctly observed that mutual funds with a high weighting in US equities and technology stocks had performed very well in recent years. What particularly perked their cognitive skills was the fact that these types of funds were now great "sellers."

They concluded that a new high tech fund and a pure-US equity fund would be ideal additions to the fund line-up. Why? The sales network was clamoring for such funds. The funds would be hot sellers.

You can guess what happened. The chairman, (yours truly, who was also the chief strategist of the fund management companies and should have known better) lost the vote. But not until after he made the board pointedly realize that for every dollar of client money that they were to attract into these new funds, at least a quarter to a third would be lost.

I was not exactly correct. In ensuing years, clients ended up with potential losses of even much more by the time the nadir of the following downturn hit. Yet, everybody else on the board thought that this was a worthwhile gamble with their client's money. The new funds were opened.

While it may seem that I am making fun of sales and marketing people, I really am not. I respect professional marketing people. Nevertheless, these experiences I have recounted demonstrate the lessons of such times. The pressures of market sentiment and the behavioral demands of the wealth management industry can be overwhelming to the best of us.

One doesn't necessarily need to be a genius to navigate financial markets. Simple common sense along with a backbone to stick with reasonable facts is mostly what you need. An understanding of classical wealth theory -- emphasizing causality and sustainability -- surely doesn't hurt. But, even more than that, one needs the guts to stand firm on the ground when pigs fly and investment markets have turned into seething pools of greed.

That, in part, explains one of the paradoxes that "bearish" money managers can face. Clients pull money away from them at the very time that they shouldn't. They effectively shoot the messenger and decamp to wealth managers with more bullish Marketing Departments and supposedly more rational strategists. Does that identify with the current environment?

10 Reasons and Bellwethers Why Being Cautious is Not Irrational

Herewith, 10 reason why a cautious investment stance at this time is not irrational.

1. New Era Thinking: Economy 2.0 Emerges. Deutsche Bank Research (DBR) recently coined a new term, "New Economy 2.0." According to their thinking, the "New Economy" that is emerging now is a better and more resilient version than the 1.0 edition -- the "new paradigm" version of the late 1990s.

We know what happened after the last time that a "new economy" was vaunted as the new panacea for eternal bull markets ... even amongst Federal Reserve chairmen. From its high, the S&P 500 index fell almost 50% from its highs at one point.

It is almost uncanny that this report should be issued just now, after the MSCI All Markets Index (USD) has taken almost 5 years to claw itself back to its March 2000 top. Having read the DBR report, I find it riddled with great marketing concepts ... and questionable theory.

2. No Workers Are Needed at All. Damn the workers and other such menial income earners. Corporate profits and financial gains will continue to soar. Why? Because labor is being beaten back as it has lost its bargaining power Apparently, to this way of thinking, negative real wage growth is a solid, long-term foundation for rising financial wealth. This is still thought to be the case even as household debt burdens are skyrocketing.

Such thinking is now one of the shibboleths of the "low inflation" thesis. However, corporate earnings are already at record levels in relation to overall GDP in North America. Can they continue to soar even if economies continue to remain robust? And, assuming the best, what should we pay for such prospects? On this basis, most equity markets are hardly a good buy currently. Markets are paying near-record valuations for cyclically-high earnings.

But then again, we can listen to the financial wizards which argue that low wage growth (which incidentally is below GDP growth) is a sustainable factor spurring earnings growth.

It is now a global phenomenon that wealth gains are again challenging the fruits of pedestrian labor (See Chart on front page) much like in the 1999-2000 period. The overall financial position value of global financial assets between 2003 and 2005 has been expanding more rapidly than the total annual world GDP. Given the pace to early May of this year, 2006 may even hit a record in this regard. How long can such financial wealth creation be sustainable?

If this foundation is so sustainable, why not ask everyone to take a 50% cut in wages in return for equity "macro economy" shares. Economists have been talking of such a security for years. Think of the result. Corporate earnings would more that quadruple and stock market capitalizations would multiply even more as intrepid Wall Streeters would also argue for a growth premium. Think of the gains ... enough to go around for everybody.

3. Solid Productivity Gains: But whose? A second aspect of new Economy 2.0 supposedly is high productivity due to the burgeoning benefits of international trade. But just what kind of productivity? Even as we still have the corporate accounting scandals of the last bull market winding through the courts, we now are in the brewing stage of a global "economic" accounting swindle.

Generally, what we see evident in the world of international trade today is production moving to lower productivity environments. For example, though China may today be the largest world's manufacturer of steel, it is far from the most efficient or least labor intensive. Yet, the world has tended to move steel production to that location. Why? Price (cheap human labor) and the opportunity for a convenient economic accounting gimmick.

It allows such countries as the US, which are showing a trend of rising trade deficits, to hide worker's bodies in the trade statistics, thereby boosting reported productivity. But, this gimmick only works as long as the deficit continues to rise.

Yes, but what of the classic notion of the efficient global division of labor? For this to be operative, international trade balances would need to be relatively contained and adjusting over time. Countries can only benefit from this exchange if they have some production advantage that they can exchange in return. Also, for this to be fact, the flip side of a international division of consumption must also be evident. That's not what we see. Instead, countries like the US are proposing an efficient exchange of consumption demand for foreign supply of labor and financing. It's not a sustainable idea.

4. Inflation 2.0. Globalization has been around for a few decades, yet most people are not yet wise to its new workings and statistical tricks. For example, a globalized world will tend to reveal its inflation in trade imbalances, not necessarily consumer prices indices or asset inflation. In the case of the US, were its trade account flat given currently high consumption levels, consumer goods inflation would be at least several percentage points higher.

Yet, some very senior people in high government administrative positions or with central banks seem to be serious when they talk of low inflationary pressures. The huge US trade deficit is mostly ignored. True inflation -- the monetary definition of it -- is very high worldwide. While Wall Street celebrates rising equity markets and enormous profits, in actuality, a process of impoverishment is taking place.

Another feature of a globalized world is that countries lose their monetary sovereignty. That happened to Canada already in the late-1980s. Thanks to the huge "carry trade" and the Bank of Japan's massive money expansion over the past 15 years, even the economically-mammoth US no longer has monetary sovereignty either.

Massive torrents of mobile international capital can completely undermine the intent of any monetary policy. That has certainly been the case ever since the US Federal Reserve began raising interest rates 2 years ago. We are now witnessing such a symptom -- the reverse of the Bond Conundrum. (See Bellwethers #9 and #10).

5. Do the Chinese Really Know What They Are Doing? In this globalized world of mobile money and hyperactive capital mobility, apparently suckers have been globalized, too. Taking a cue from W. C. Fields, it would be immoral not to take advantage of them. As he once quipped, "It is immoral to let a sucker keep his money."

America is surely milking its "seignorage rights" for all it is worth as the world's reserve currency. As a deficit nation, it borrows money abroad in its own currency. China (among other Asian surplus countries) chooses to convert much of their US export earnings into US IOUs. The establishment economists soothingly coo that this represents a process that will go on for quite some time. So, no need to worry ... yet. But who is the sucker? The Chinese?

But, is it possible that such apparent stupidity on the part of the Chinese would be just too obvious to be believable? China surely knows that it may suffer huge losses on its US-dollar denominated currency reserves should the US dollar fall or its bond markets turn down. Apparently, then, this must be a calculated gamble ... a potential cost that has been counted ... even at the expense of being openly played the fool. For example, over the past year China has been openly snubbed with the effective message, "Your US dollars are only good to buy our effluent ... our debt."

Can we really believe that this country of Confucian heritage should be so unwise? Before China began withdrawing from the industrial world some two centuries ago, it had been the world's largest economy for at least 18 centuries (according to economic historians such as Angus Maddison) and a leader in many other respects. What then is the real agenda?

In a world that is as hypercharged geopolitically as ever these days, let's instead consider this question: Is it wise to allow one's country to fall into the vulnerable position of allowing other nations to accumulate a huge long position in its tradable debt securities (now well through $2 trillion) even as a new world contender for a world reserve currency has arrived on the scene?

No, this is not wise ... certainly not as this country's currency, the US dollar, is again declining against the euro. Yes, the game may continue a while longer, but it is not sustainable and its apotheosis will be grim. We therefore continue to emphasize non-US dollar assets in our global portfolios.

6. Unlimited Pockets of the Fed. Quite a few scholars, including the new head of the world's most influential monetary institution, think that the powers of a central bank are virtually unlimited. Apparently, there's no limit to what can be monetized as long as respected institutions and popular magicians are engaged in the alchemy.

Should the central bank ever run out of government debt to buy for its balance sheet, perhaps they may even eventually buy baseball card collections were a clever financier ever to invent cardboard-backed debt obligations. (The paper version has already been invented.) Some of the Fed faithful are so blinded, one hears arguments that there never again can be a general deflation ... not even a credit deflation.

All the while, however, we see a wealth skew continuing to stratify and skew in North America (as well as elsewhere) to the highest levels on record by some counts. Interest payments as a percentage of personal income continue to rise. What that means is that the income coverage of the financial obligations of the median household is deteriorating rapidly.

After all, the interest income of the richer people are part of overall household income to begin with. What that then implies is that available income for the majority of households, after deducting interest income from total household income, is much worse than general statistics imply.

Creditors and consumers are playing to the hilt. Obviously, this process is not sustainable -- certainly not as interest rates continue to rise. Despite the objections to the contrary, and even if the Fed's pockets are unlimited, the risk of a credit deflation is rising. To believe otherwise is to assume that irrationality is sustainable forever no matter the income and debt-service dynamics.

7. I'll Buy Your House if You Buy Mine. Back in the days when the world economy might have had only two households -- let's say, Adam and Eve and one other unknown couple, Barney and Stella-- the first residential bubble might already have occurred. Adam refinanced his hut every year and so did Barney and Stella.

It was a very sustainable ruse as long as it was agreed that hut prices were to rise 10% every year, interest rates to remain low and mortgagors to offer the option of capitalizing the interest cost. Soon both families felt very wealthy. Their houses were worth 1 million coconuts each and their portfolio of mortgagedbacked securities was doing nicely, too. But, were they actually richer? Not at all. They still lived in two huts and now owned a huge call position on a lot of coconuts that really couldn't be paid for or harvested. So was life in idyllic and rational Eden.

In real life, this same phenomenon is occurring today, although with quite a few more complexities. We see the added effect of overconsumption as a result. The point is that this type of Ponzi scheme is not sustainable, only for a while. And now, housing markets have definitely turned down. It is bound to have a slowing impact on economic growth over the next few years. If not, it will require a lot more coconuts to keep it going.

According to one source, real-estate value to GDP is nearly twice as high as the average from 1952 to 1970.

8. Rising Earnings from Money. The Economist magazine recently profiled Goldman Sachs as "On top of the world." The investment banks are making obscene profits right now, as they usually do at cyclical turns. However, there is much more behind the earnings boom at Goldman Sachs and its bulgebracket brethren than a cyclical bull market. Financial earnings overall show no sign of retreating from their secular 50-year rise as a proportion of overall corporate earnings and national income.

We made the point, in a previous Global Spin (See The End of Financialization ... Maybe) "[...] that if one were to extrapolate the recent growth of financial earnings vis-à-vis its share growth of total national income, in 25 years greater than 30% of net national income would be captured by the profits of this sector. That won't happen because it is simply impossible. Financial services by their very nature need to remain symbiotically parasitic."

By the way, that level of financial earnings would be approximately triple that of total domestic corporate earnings today.

Conclusion? The trends we see at work are not sustainable. Money cannot be made from money to such an extent ... not even indefinitely at the levels witnessed today. A reversal is due at some point. But, for now, a heavy financial weighting is still a popular strategy. Irrational?

9. Bond Market Reaction to "Pause Message." The world may no longer want to accommodate US demands for global savings. An important confirmation of this may have already occurred. As soon as the Bernanke Fed suggested that it may stop raising rates this past April -- even if only temporarily -- bond markets didn't like it. What we saw was the opposite of the "Bond Conundrum" of spring 2005. US long-term rates are rising and the US dollar is falling as the end of the Fed rate rises nears.

Will we see more of this? Very likely. As the point nears that short-term interest rates will again be lowered, long-term bond yields will stay sticky ... more likely even rise further. That leads to our last point.

10. Europe and the Euro are Tortoises. Optimism on the US dollar is unsustainable. In fact, the US dollar can be expected to enter a more volatile stage of decline if Bellwether #9 plays out. We still anticipate that the euro could make new highs against the US dollar, even well exceeding the equivalent high to the D-mark recorded back in 1996 (144.5 USD) That perspective will surely make us appear irrational. See our previous Global Spin entitled The Euro: Why the Tortoise Could Yet Beat the Hare for a more detailed overview.

Conclusions

We may be totally irrational, but we think we see numerous developments that are not sustainable. We could surely mention many more bellwethers than just 10. Yes, all of them could continue far longer than we may stay sane, but they are surely not sustainable. Quoting Herbert Stein, "If something cannot go on forever, it will stop." Eventually.

Just what developments might intervene? We identify at least five shifts that are moving the tectonic plates lying underneath all of these unsustainable trends. Most of these fall into the geo-political category.

1. China, though its economy seems as unstoppable as ever, declared a new 5-year plan earlier this year. Economic growth is still an important objective, however, other priorities have moved to the forefront such as environmental concerns and a more balanced wealth distribution. China, India and other fast growing nations are surely not invulnerable to slowdowns or sharp downturns. That can have implications for the redhot commodity markets.

2. Japan has stopped its policy of "quantitative easing." This great polluter of the world's monetary waters is no longer expanding its monetary base. It sits atop the world's biggest bond bubble and possesses the most intractable of government spending deficit of any major developed nation. Yet is now being lionized as a revived economy. Its slowing monetary base signals a tighter leash on global market conditions and the rampant and inflationary "carry trade."

3. A New Monetary Climate. World money growth, though still strong, is showing signs of slowing for the first time in years. A new cooling wind is blowing. Also, a period of negative real rates is likely coming to an end worldwide.

4. Geopolitical Instabilities. Geopolitical crosscurrents introduce sources of potential instability. An independent, value-free China, a growingly belligerent Russia, and non-aligned states such as Venezuela are roiling the pot. Also, the implications of a West that has split into two and sundry Mid-Eastern issues, add to unstable geo-political conditions, especially so for the US.

Oil prices have already adjusted to these potential dangers to a large extent. However, crucially, none of the above conditions are favorable for the US dollar. All of this means that the "peace dividend" following the Cold War is history.

5. Housing Downturn. The housing price boom of recent years seems to be rolling over in a number of countries. Notwithstanding the UK recovery in housing activity prices over the past half year, this development is still destined to have an impact on consumer spending. Housing affordability remains poor in the UK.

Currently, mortgage refinancing is still generating a high level of cash take-outs in the US. Inevitably, this source of spending is likely to slow, acting as a brake on economic activity. Now that these dynamics are beginning to come to the foreground, we should remember the lessons from past real estate bubbles. There are numerous studies from a number of respected organizations that have concluded that the economic fall-out of a real estate bubble is far worse than a stock market bubble.

The year 2000 witnessed the top of a stock market bubble. In 2006, we may be at the peak of both financial securities and a real estate bubble, this time of global proportions.

Currently, there is definitely much speculation evident in global financial markets. Risk is as cheaply valued as perhaps in a century or more.

Yes, admittedly, one cannot predict irrational behavior nor accidents. Definitionally, that is impossible. However, one can identify periods where a high incidence of either seems likely. That said, we still cannot offer any reliable short-term predictions. There is no limit to irrationality and we are hopelessly entangled with logical theories.

But, irrationality does play a definite part in investment market cycles. Walter Bagehot, the famous editor of the Economist in the mid-1800s once wrote, "At particular times a great deal of stupid people have a great deal of stupid money and there is speculation and there is panic."

As documented, we see lots of reasons arguing that is very irrational not to prepare for alternate investment scenarios, other than the optimal eternal boom scenario.

If our feeble reasonings are wrong -- or much too early -- we can always blame it upon uncooperative terrorists, microbes and an unlimited supply of coconuts.

We are cautious and continue to remove lowvalued risk from our portfolios.

Wilfred Hahn
Hahn Investment Stewards & Company Inc.

The Global Spin is published and distributed by Hahn Investment Stewards & Company Inc., serving to provide comment and analysis on important economic and investment issues of relevance to general investors not otherwise widely available in the public domain.

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This report was produced by: Hahn Investment Stewards & Company Inc. Phone: 888-957-0602 and is for distribution only under such circumstances as may be permitted by applicable law. It has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. It is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the report. The report should not be regarded by recipients as a substitute for the exercise of their own judgment. Any opinions expressed in this report are subject to change without notice. © 2005 All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Hahn Investment Stewards & Company Inc. The Global Spin is published twice monthly at an annual subscription price of $250.

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