Instruments of Deforestation
A generation ago, bond and fixed income investors suffered as the very flesh of their holdings was devoured by inflation and rising interest rates, and bonds became "instruments of confiscation". Now, the path to the recent US economic recovery is connected to an enormous amount of timber-related assets if you will. By that, we mean paper (and electronic) assets in the form of the US dollar's continual recycling, by creditors like China and Japan, into US treasuries and the popularity in lumber-derivatives, in the form of mortgage debt and homes. A virtual forest of paper assets has been harvested and we wonder about the odds of a credit contraction and conflagration, wherein the recent recovery, since the official "bottom" of November 2001, goes up in smoke. We take the spirit of the painful phrase and start our consideration of Instruments of Deforestation.
We're still optimistic about the long-term potential of China (who is not?) with an eye to some profit taking in the near-term, we're not so gung-ho on Japan as we were a few months ago. Individual values likely are to be found in Japan but the aggregate picture prompts profit taking, with the exception of perhaps some Japanese auto trades. Japanese autos have been in sharp contrast to the continuing bad news for F, GM and DCX, and the recent sales incentives have failed to gas up sales. Speaking of gas, we believe flashy poor fuel economy models are destined for the junkyard, thanks to collisions with rising energy prices. We, also drill lightly into the subject of black gold, and have mined our thoughts about real gold - suggesting a less than direct investment application, and then close this Market Note as we muse, very very briefly, about 2005.
The pulp fiction of the market rise masks a rising indebtedness and an increasingly fatigued US Consumer, one of two engines of demand and growth we're focused on. Employment, about three years after the official bottoming of the recession in November 2001, is still weaker than anticipated but we all keep borrowing and spending. The homebuilding shares we worried about did decline, only to have rebounded along with equally resurgent mortgage borrowing activity. Recently however, Pulte Homes reported they were cutting prices and the entire sector has taken some new lumps. Stop loss orders and/or risk management rules have saved us Roosters from the pain of insisting upon the "rightness" of any particular view, especially the notion that raised interest rates, thrice since June 2004, would be accompanied by lowering asset values, new declines are now prodding us to either exit recent longs or go sell and/or short again (woof!). As to the notion of lowered asset values following heightened credit risk costs, reports from places like Morgan Stanley hint that others believed the same thing and acted accordingly - their recent quarterly report indicated they were given short-shrift for their bond trades. What is at the center of the contradiction? What is at the middle of this? We believe in part we should look to the Middle Kingdom, China.
The second engine of global growth has been China, as one of the biggest buyers of raw materials. Gorged with the primary US export, the greenback, China has also been one of the biggest buyers of the leading Deforestation paper, US Treasuries. Now, after the formal changing of the guard, from Jiang Zemin to Hu Jintao, we perceive not only China's continued march toward economic leadership but a firmer resolve to use the brakes as well. This past decade alone has been witness to China's rise as a "G7" level participant, the recently deployment of Chinese UN peacekeepers, and new entrants in Formula 1 racing (and don't forget that minor gathering known as the 2008 Olympics). The impact on raw material prices will, in our opinion, continue to drift upwards, with occasional interruption and disruption. This will be the course as China's credit risk management culture is evolving, haphazardly under Beijing's official insistence while those with hands (and feet) stuck in business deals (e.g. various Party officials, their friends and relatives, and local authority big-shots) will continue to offer not exactly disinterested resistance to this stricter credit regime. The damage done to those who shorted bonds, or the homebuilder market is not a permanent condition. Bill Gross, of Pimco, warned in a recent release that bond buyers should mark some kind of exit in the face of a 4% yield environment - we agree. The anticipation related to three hikes and a stumble may prove true and bond bears may have been a little early. As always, however, risk management goes a long way.
A somewhat contrarian signal may be the recent registration of a real China ETFs, including an iShares FTSE/ Xinhua China 25 fund. We welcome the opportunity to go long and accumulate over the next few years, particularly when things might become gloomy in the near-term for the retail and fee-incentivized institutional herds. Why oh why should we fret? Our worries, in a nutshell, is that good things can't last and gosh have things been very good all around, based upon all the attention and cut-throat competition by Wall Street biggies for a piece of the biggest pie on Earth itself. Firms including Barclays Global Investors may have applied for SEC approval at the near-term top, but that's our inner-contrarian's disquiet over the boom.
We are witness to a China coming to grips with its interest rate environment in an increasingly un-command-like economy, as nascent curb markets for credit begin to distort official money supply figures, just when an emerging agriculture supply demand gap becomes more problematic. These are just some of the things on our mind about all this Re-awakening Giant (and Consumer of everything). We are also captive to a Market Absolutist State playing in the energy markets (in the form of Russia under Putin's machine), but could look to Canada, a quaint holdout of democracy in an age of revived Statism. At the same time, former crude oil supply bogeyman OPEC seems to have even less of a say than the old Texas Rail Commission, which helped to run the energy show during a pre-1972 era. OPEC appears to have been producing flat out, including more of the Saudi thick sour crude - while the markets cry out (in the trading pits at least) for the light sweet variety. All this as $50 oil has been called "cheap" by those with long memories and calculators set for inflation adjusted prices going back a couple of decades.
Japan, the other barrier to bond bears, is also a holder and buyer of the same US Treasuries and may be further disruption for a near-term bearish bond view. Our concerns, legitimate or not, makes us not so much bearish as feeling maybe some of the starch is out of this one. We were not feeling good for most of this summer and maybe its time to consider putting in the triggers and stops on a Japan long position or moving on altogether to something else. Recent growth news has not been encouraging. While we don't doubt the validity of individual value investment turnaround ideas, we think the big trades maybe done for now, that the trend has already been ridden out for now.
Recent disappointing Japanese growth figures are a concern for us. The downward revision in second quarter GDP underscored the misgivings in our minds about this trade. For the quarter ended June 2004, GDP expanded by 1.3 percent and not by the1.7 percent estimated. While the market chatter has moved on from the wondering whether or not the Japanese economy is in recovery and has moved from deflation to expansion, we are still mindful of the trade itself. Recent noises about Postal Office privatization (which is in the opposite direction to the possible reemergence of Statism) caught our attention as the restructuring of the Japanese economy continues, but this mature economy doesn't look so compelling. We just can't help but notice the gradual lowering of recent highs, as the market edges lower and lower. Risk management, as always to allow for your pre-planned exits can't hurt as much as loss of equity.
Stepping back from the day-to-day movement of the market was one way we have tried to make sense of what to do. Out of the esteemed firm of Smithers & Company, we are reminded that from the 10,000 feet elevation view of the Japanese market, that while valuation of the equity market is problematic, it appears pricey, with the net worth at replacement cost of non-financial businesses not valued much more than book value, and with an overall price to earnings ratio in the mid 20s range for profit margins just above US levels which are themselves described as barely above average. (To our eyes as well, this aggregate P/E seems an understandable metric for a growing young ingénue economy, perhaps of the emerging markets variety, but troubling for a mature economy).
A stumbling block for the Smithers firm included a paucity of hard official data for things like net worth at replacement cost and even earnings and dividend data (there go "reliable" earnings yield guestimates). Another problem is land as a component of corporate net worth is considerable. The heft of this component would require property to be worth double book value for the replacement cost of company assets to match stock market valuations, to eliminate the overvaluation of stock value to book value. (A tangential surmise by the Smithers firm: Were this higher valuation assigned to the property on the books, this would mean those long Japan would be effectively just trading shares in real estate with side-ventures in various industrial businesses.) Going back to the "q" ratio we mentioned in the past (replacement cost of assets) or a normalized P/E ratio, Japan looks pricey. The topper is that they estimate that the stock market is worth book value and is overpriced by a stunning 60%, comparable to the US. (Some of our readers maybe intrigued, amused or inflamed, and we heartily recommend they consider subscribing this firm's research.)
Yields for 2 and 10 year JGBs (source: www.asianbondsonline.com)
Homebuilders. "The roof, the roof, the roof (was) on fire..."
The roof was raised again on Homebuilder stocks, as we see from a charts, including an updated MBA mortgage index, provided below. Post-hurricane housing stock in the southern U.S. may have to be restored but these markets do whatever they want to do. Again, we got knocked out by our mechanical, anti-ego equity risk management rules, and we don't doubt some folks turned long to go up the stairs being nailed up, plank by plank, with the return of mortgage activity. The problem is sure, it seems rate hikes are "priced in", but does the end user, the homebuyer know that too? How many times will there be a rush to "lock" in rates before the next hike? Will that always give a lift to shares or will the marginal bid in this market peter out as well?
If two of the bigger customers for US Treasuries, China and Japan, have other things on their minds beyond recycling dollars, then the 4% yield touched upon may prove to be a rough zone where a recent "top" was made for bonds. Another source of "Deforestation" paper, Fannie Mae, given its recent stumbling, while not necessarily a fatal moment for the homebuilder market, is nevertheless a trouble spot. As another big buyer of debtor paper and supplier of liquidity - as a buyer of the Mom, Apple Pie and American Dream mortgage paper - Fannie's move to "clean house" can't be ignored. While the housing market will not collapse overnight from a bout of repentant behavior, given the heft of Fannie's balance sheets, (at about $895B in size), makes our forest of debt a tinder-box waiting for another spark. Were the unspoken risk-discount that underlies Fannie as a GSE suddenly shrunk, thanks to greater stringency and oversight, or even management self-restraint, what then for homebuilding and home equity lines and US Consumers? Anything is possible.
To sum up the subtext of our fears about the Instruments of Deforestation - while the Fed is focused on fighting inflation, China and Japan inevitably have their own houses to attend to (no pun intended), and as Fannie Mae and homebuilders face their own possible fire sales. Saplings of future growth may have been uprooted thanks to the dramatic debt deforestation carried on to prop up this post-boom age. It may take years to recover and re-grow the forest of future prosperity.
Back to the US Consumer, we reiterate our observation about the US auto industry and reiterate what the markets are telling us. The recent pop-up in September figures doesn't change the fact that the US Consumer is fatigued. Ford is still running at the end of the pack, and at the same time Japanese makers were doing okay. Toyota, we believe cut incentives and it appears to be eating the competition's lunch. No, we're not always right (that's what stops and equity risk controls are for folks, to win despite ourselves), we see that US consumers and autos continuing to roll in this direction. (No, our macro-call on Japan remains.)
From Japan to back home here in the USA, what's going on with unemployment, and inflation? The recent disappointment underscores the markets' wariness about the continued growth path for the US. Speaking of inflation, can inflation concerns be unwarranted? WE don't think so, let's take a revisit to our opinion a few months ago about volatile part of the CPI, the most decidedly NON-core CPI regarding food and energy, the part that we spend our time with when we go the market, eat, turn on the switch, turn the key in the car, you get the idea. Prices still seem headed north.
About "black" gold: The stuff that goes into the cars and plane, and heats the house, makes chemicals that we use, etc., just keeps going on up, and may do so over the next few years, with occasional "buying opportunities".
We reiterate that risk management is very important, no matter how compelling, how "right" the idea is. (And we'll keep pounding on the table about that no matter what.) The markets do what they do, regardless of our "genius" or "madness". Case in point is a revisit to the energy sector, to the Baltic dry index and the fact that oil is bubbling, no not "bubble"-ing, so much as seeping into the collective conscious of the markets. For a trading idea, consider our September 2004 Trend Note. At recent prices, we're still not much higher than the inflation adjusted price of crude from the first Gulf War, so it may very well be that much more is to come.
The Sweet Smell of Success (chart of light sweet crude price; November 2004 contract; source: John Deere)
About real gold: An asset class that barely won the Bronze medal this past year (so far) may be back - but as the price heads north, we are thinking of going long South Africa.
We've always thought about gold, same as everyone else ever since that Bank of England auction about five years ago. The run-up and profit taking may be followed by waves, given the condition of debt and the post-bubble unwinding (and re-winding and unwinding). At the least, it's another parking spot for paper cash. Inflation or deflation, the noble metal has its place, excess of the past particularly in the ongoing credit abuse of recent years, egged on by the Fed's lavish liquidity just can't be ignored. No, unfortunately, it's not too late to consider gold, from the perspective of the economic recovery. Outside of the shelter aspect, alchemists will transmute the Chinese growth story into one about the revival of a gold market in the middle kingdom for the private citizenry, seeing as any central bank ambitions to stock up reserves with more bars as impractical to execute in the near-term. We don't think past mal-investment has been liquidated or reorganized out of the system, far from it, with the ascension of credit swap market meant to hedge away risk (remember portfolio insurance from "way back" in the 1980s, and think of something even bigger and growing.)
The price of gold shines again (source: www.kitco.com)
We apologize for sounding and talking like gold bugs, since we like growth ideas as much as gold. Big picture, we like gold as a hedge against rising prices, which we see happening, like it or not, thanks to a variety of reasons, from boosted liquidity intended to keep the recovery rolling, to war spending, to overseas demand prospects (yes, we mean China in the longer run). We like the idea of some store of value, in metal and in shares. The great James Grant, of Grant's Interest Rate Observer, wrote a wonderful piece called "Value Hedge" last year and it is a wonderful discourse about gold. (Jim observes far more than just interest rates, for those of you who don't know about him, but most of you likely are readers of his work, and consider our scribblings laughable.)
No, that does not mean we will be talking about NEM, the bell-weather pick, but we will wield our interest as an excuse to move onto a pet subject we've held off discussing for months - South Africa. Let's drill down to one arena of this area, gold and South Africa and South African stocks - prompted by our thoughts about the rand and the hike in interest rates, which finally came. Natural resource stocks seem iffy, but if you must buy then perhaps this is the way to go. Let's take a quick look at ASA the discount that was there, and which may unfortunately grow larger were these assets to fall out of favor. Sure you could consider Sasol (another vehicle for oil and energy exposure on a global basis), but we're also interested in Anglo American - not exactly imaginative or exciting, but the company is certainly a longer-term play worth the trouble.
The gold favorite likely to be favored more and more, including us, over time is NEM:
A look at the chart for AAUK among other issues and give brief consideration to what could be something more worthwhile for some traders down the line. Would you short it were you more pessimistic about materials and metals and bullish (short term) about the US dollar? That is the trade for those who see near-term, weaker gold and metals, meaning a hit for Anglo American and Harmony gold. Should at the same time oil prices retreat too, (why not a little backing and filling, in the minds of some traders, after such a recent rise?), that means a hit for players like Sasol.
If you anticipate further US rate hikes, and in future softness in gold (an already soft metal, no kidding), and in China's landing (soft or hard), then you also anticipate their collective impact on raw materials and emerging markets' vulnerability (as they are completely exposed to their best customer's (hard or soft) landing), then please excuse our attempt to entertain our notions about where to go hunting both for the yellow dog, and not incidentally raw material in one of the more unpopular of places to go long gold.
On the political side of this trade, there is also the issue of umbrage taken by Mbeki over remarks from Anglo American and Sasol regarding sovereign risk. We thought the flap, very understandable given the historical weight of the issue, is not to be taken lightly, but we are also optimistic, that in time mutual interests will be met and everyone will see that all parties, like it or not are in it together at the same side of the table and that the common good will be served, which we respectfully submit is common prosperity by the meeting of self-interests. In fact, misgivings in reaction to the SEC regulatory disclosures about sovereign risk will be given more leeway overtime. Hopefully, Barclays' bid, successful or not, for the largest bank in South Africa, Absa, doesn't become a too prominent lightning rod for outraged workers or politicians (We don't want to take sides since we feel we are all in this together and we apologize to our readers for making any comment at all.)
True, the decline in S.Africa's contribution to gold production, went from something like 1,100 tons in 1970 (to supply 68% of the world's production) down to about 330 tons, or 13% of global production. In addition the strength of the rand beat down profits, but rand weakness, thanks to a rate cut, maybe part of the key for the long trade. If the rand price of gold, around 80,000 rand per kilogram could move in the right direction, then profitability comes back for the miners. In the meantime, the greater raw materials secular bull is also a key pillar to our suggestion to check out AAUK (a basket of platinum, gold, diamond and coal). The recent DeBeers diamond market settlement with the US after years of recalcitrance, is a positive note. The great overhang in the regulatory atmosphere and in contentious relations between government and management, a legacy of the country's past, will be resolved somehow over time.
No, the yields of South African shares may not revisit their former glory. A generation ago, the macro proposition was that the rand-dollar rate was fixed and the revenue was rich at a time of rampant US inflation, showering S. Africa with dollars, which flowed to corporate profits and ultimately spewed out a torrent of dividends. We don't know if this is likely to repeat, but we like the change in political regime, although we are troubled by the Keynesian policy stance of the current administration. We are however hopeful that the invisible hand of the markets will help and result in great share prosperity in the long run (if you're not an optimist for the long run, then what is the point after all?)
A specific issue for one investment ASA, the closed end fund, is that certain capital gains taxes have been extended to November 30, 2004. The management of ASA is trying to move to Bermuda to solve the problem for shareholders but it faces hurdles with the US SEC. If the move is after Nov. 30 or if there's a liquidation, then a tax of $25M has been anticipated (equal to around $US 2.60) including a $5.5M deferred capital gains liability. The discount to NAV is around 10+%. The long idea for ASA is premised upon the success of this fund's ability to move to Bermuda. If this happens, then only considerations of the rand, raw material prices and government policies towards business, like ASA portfolio companies including AAUK and SSL are all we have to concern ourselves with - no sweat. (Well if this was easy, everyone would be doing it.)
The saving grace for SSL is of course energy prices over time. A lower rand and higher prices would be a nice boost for SSL, as it would be for other South African trades. The longer run, bigger picture favors raw materials, and prices and these shares, with their unique circumstances, will still participate in that greater trend. We offer below charts of the Rand's recent moves and the ideas we've suggested. Not the most favored picks for gold and raw materials, but still worthy of consideration. When time permits, we are inclined to further address these notions in a separate Trend Note. We wonder if South African shares are headed north for a while longer.
A closing thought, for now, about gold, tying in to our earlier US macro overview. The beaten down US dollar may have a rebound coming to it, to gold's detriment, but the trade deficit overhang, as we've discussed in the past, is not going away. The rate hikes are bound to continue, in fact Fed member Gramlich said Sept 16, 2004 or so that a rate hike would have to be endured, even at the price of employment impacts, and that experiencing price rises, a rate hike and lower employment should not come off as a surprise out of the blue. If the dollar bounces and gold gets hit, then the buy and holder in us says buy more metal. While the recent action in gold attracted those ravaged by the 2000 bubble bust, the money has since moved back to the rebound in other equities from fall 2002/spring 2003, and we read about disenchantment and selling of speculative positions in gold. Fine by us, the great 1960s bull that burst in equities, was proclaimed dead by business week years later, after years and years of unwinding. Gold was "dead" to the public consciousness for almost a generation, and so it may go through a long awakening long after it came back around 1998/1999 in stop and start fashion - attracting us only after the Bank of England gave up the ghost and 280 tons were auctioned away just like that.
If the dollar bounces, its temporary, as the long march towards an increasingly depreciating fiat currency, accompanied by mining production constraints, the unwinding of outstanding hedges and the lead time between real discovery and production only adds to the bigger "bullish" story. Peter Bernstein's entertaining text, the Power of Gold talks about a centuries old currency that was common currency (literally) used in a prosperous empire in decline. No, we weren't talking about the British Pound, we were thinking about the Bezant, that coin of the realm of Byzantium, that half of the Roman Empire that went on to live long after Rome was co-opted by the Goths.
Strike while the iron is hot:
Industrial metals: The recent resurgence pop-up for an assets like copper which we considered overheated over six months ago makes us worried again. The action in metals, hotter than what's happening for gold, and riding the coattails of the action in oil has been back, pushing prices to 52 week and beyond highs. Our stops kicked us out on selling short these trades, and followed by lots of long signals, invariably accompanied by right brain fundamental reasons to go long. The popup, driven by China and its seemingly unstoppable growth (soft landing is another debate for a subsequent issue), and the remnants of the Yankee Carry Trade we harangued against during the Spring 2004, will be followed by another correction, a view echoed by such things as the OECD estimation that global growth peaked in H1 2004, with a slowdown for 2005 and by a China slowdown, like it or not. But, "smart" ideas are one thing, trades are another - so we like to make money. Let's revisit the charts and see what is happening now.
"High Plateau Drifter" - Do we keep drifting back and forth in 2005?
The overall indices may have masked gains in various individual issues, but we still worry. Sure, insider purchases have been on the rise and there may be more consolidation buying post-summer, but this may fizzle in a few months. The back and forth in securities prices has been a source of some consternation, outside the big trend plays, and while it may fool some into thinking that we've hit some Irving Fisher type of situation, a recent highs plateau (somewhat lower than the one we all enjoyed a few years ago but higher than the "bottom" of 2001/2002) to mark an era of fair-to-middling markets to come, we are bracing bad times to come starting some time in 2005.
Another insightful study from Smithers & Company asserts the non-random nature of market returns, and that given the recent performance of the markets, a period of sub-historical mean returns is more likely than not. In an Barron's interview almost a year ago, money manager Hugh Hendry, suggested a correction that could disabuse the buy the dip and buy-and-hold mentality which we believe also pervades pension funds. We read recently that the Economic Cycle Research Institute (ECRI) index declined and that the ECRI opined that we were headed for a slowdown. Another money manager interviewed earlier this year, Peter Thiel, opined that the Fed, in the event that the homebuilding industry and overall recovery are threatened, might even be inclined to lower rates (!), but that seems to mean something good for bonds after in anticipation of bad things happening first. In closing, we don't know about 2005, but we are a little skittish, election, no election, New president, old incumbent, oversold, not oversold, growing deficit, shrinking deficit, no matter what, we come up with a sense of caution about 2005, that the rally that was on from late 2002 and into 2004, not only has run its course, but may be laying up for a bigger reversal than anticipated. Again, as usual we think the future is unknowable, but that is our job in part to shoot off our mouths and surmise and offer a framework. Another big to noise in the cauldron of data that we all swim in yes, but we do our best to keep humble as a result.