1 Comment Written by Anthony Truong on May 26, 2008 – 6:59 pm

The following is a response to a hybrid article from both the Daily Reckoning and their sister publication, Money Morning, on 26 May 2008. I have decided to post my remarks first, with the corresponding articles below, as they are rather lengthy and I would prefer you to read what I have to say!

In either case, you can find the Money Morning articles here and here, and the Daily Reckoning articles here and here.

I disagree with a lot of their arguments, due to the fact that they attempt to write about causal or correlated relationships between separate financial markets (i.e. gold and stocks, or crude and platinum). Each financial market has different players, therefore they CAN’T be correlated, at least not on a long term basis. Sure, on a particular day, stocks will fall as crude rises, but then what happens to their arguments if stocks rise while crude rises? Or gold rises while stocks rise? Hmmm… It gets complicated.

What we have to realise is that each and every market is separate and distinct, and are following their own patterns and trends, regardless of what’s happening on the “outside” (events, other markets, political movements, etc). Buyers and sellers within each individual market determine prices for that market; when they agree on a specific price, that’s what goes to the market and that’s how prices are determined, not by gold or silver or crude or other stocks.

It’s the psychology of the buyers/sellers in each market that’s important, not what “events” are occurring outside that market. If they are bullish, sellers will want to sell at a higher price and buyers will be willing to buy at a higher price. If bearish, the opposite is true; this is regardless of what’s happening in Iraq or Nigeria or China or the US, or what the Fed has to say.

Another note; they seem to dismiss the fact that equity markets across the globe are connected through global credit. They mention that this was the case last year, but this year Australian indices are being pulled by resources, and therefore we are no longer “coupled” with the US (and perhaps the rest of the world). I think it’s dangerous to assume that we are no longer prone to volatility in credit markets; we do have a heavy resource-based economy/market, but credit makes everything flow nicely and smoothly (for a time, at least), and that credit is obtained and sold globally.

When things go bad (credit defaults or mass selling of credit derivatives), it doesn’t matter that we have a great iron relationship with China; the companies that have the iron will no doubt feel the effects of further bursting of the credit bubble, as those holding their shares sell en masse into the markets at whatever price they can get. When you get large amounts of selling, everyone will want to run for the exits at the same time.

I’ll explain this another way: you have a healthy company, say BHP, mines all sorts of things, including iron. It sells hefty amounts to China, generating huge amounts of profits. However, on the other side you have an investor, holding shares of BHP. This investor has a mortgage, takes out loans for personal luxuries and also to buy stocks (a lot of people take out margin loans to buy stocks these days). So he’s leveraged; margin loans are notorious for high amounts of leverage, hence the problems with Opus Prime and other brokers. If there is even a slight fall in BHP’s price, the investor may receive a margin call, i.e. he has to front up more cash to cover his losing position. He may choose to sell shares himself to cover the call, or in tight situations, what’s most likely is that the broker will sell his shares for him to cover the margin call. If this happens, there’s a sudden spike in selling volume; other people follow this lead and sell, reducing the price further; other investors receive margin calls, sell some more, blah blah, you get my point; it’s a vicious cycle.

That’s just a small example; now imagine that happening to a bank, and it having to sell shares (i.e. Societe Generale after learning of Jerome Kerviel’s trades [which, allegedly, at the time were profitable, but since the bank has policies to restrict the maximum amount that can be exposed on an account, it was forced to sell its positions that then created losses]). To further emphasise this point, economists and financial analysts generally estimate the US subprime mortgage market to be valued in the range of $2 trillion (i.e. we haven’t seen anything yet in terms of subprime meltdown). Now get this: credit derivatives contracts (which encompass any type of asset that is related to credit [CDO's, MBO's, SIV's, bonds, swaps, etc]) that were outstanding at the end of 2007 were estimated at a total value of $62 trillion. What do you think will happen if that unwinds itself?

Further reading:

Resources and Mining Take the Wheel from Financials

By Al Robinson, 26 May, 2008

Asset-based investments are beginning to dominate the ASX in market value. The mining sector is now worth $406 billion in market cap. Financials have fallen to $403 billion. The king is dead. Long live the king.

Of course, financial companies have assets. But they’re not tangible things. You can throw a rock at your neighbour’s window, and it’ll shatter. If you throw a mortgage-backed asset at your neighbour’s window, he’ll probably run shrieking out his own front door all the same. But the window won’t break.

Real tangible assets are in a bull market at the moment. A non-imaginary one. The values of commodities can be identified in real markets. There are real people buying these things, and transporting them to real countries in real ships. They crush them and cook them with real machinery, then sell the refined product to a real end-use.

We may very well see a bubble develop in the commodities boom soon. Anywhere where there’s a good opportunity, greed and opportunism follow. But the real nature of this boom is what sets it apart from booms in technological speculation or financial earnings.

Now here’s the important part…what happens now that the mining sector is the undisputed leader of the market?

Could this be a symptom of the much-maligned “decoupling” theory?

Commentators slaughtered the idea last year. The Aussie market fell just as fast as the US. Indeed, global equity markets fell in unison. But that was when the Aussie market had finance as its lifeblood.

Since then, trade with other countries has increased. Our five top exports are all resource offerings. Iron…two types of coal…oil…and wheat. There are no securitised assets or government debt on that list. Just useful things.

A true decoupling can’t happen yet. That would, among other items, require a major overhaul of the international currency system. But a-mini decoupling of sorts is already happening in the Aussie economy. Every time we export more iron to China, we have a little less to do with the US economy.

Chinese Wheat Production Hit by Disease

China’s National Bureau of Statistics says the country’s largest wheat-producing province won’t be breaking any records this year. Henan Province is facing disease, not to mention rising costs from oil and fertiliser booms.

Woe, woe, woe…

It’s a disconcerting fact that agricultural production today is an oil-based business. We turn natural resources into food. Petrol fuels the massive machinery that mass-production farming requires. Phosphate, potassium and nitrogen make up the chemical fertiliser that stimulates extra returns on crops.

Rising prices wouldn’t so much of a problem if Chinese farmers could make up the difference with a good year. But pests are making the situation harder. ‘Sharp eyeshot disease’ is expected to take its toll on Chinese wheat fields this year.

As we said earlier, wheat is one of Australia’s top exports. If China can’t get enough wheat, it’ll look to us. Now that AWB (ASX:AWB) has lost its grip on the exporting trade, a few second-tier wheat players may be worth a look…

Gold in a Good Place for Buying

If money’s moving out of stocks, where will it go?

It might be time to take another look at the ultimate alternative, gold. It hasn’t made a major move since it came back from US$1000. Gold costs US$920 this morning. Our hunch is that that’ll change in the next month or so.

Good investing,
Al Robinson

Platinum Ready for New Bull Leg

by Gabriel Andre on May 26, 2008

How do you describe an investment that explodes for a 50% gain in 40 days? Boom!

A more accurate word would be “platinum”.Since its initial burst, platinum eased off the accelerator and dropped back down to the stratosphere. It remains on a bullish trend, however. After the correction, buyers took advantage, and got back into a good fundamental trade.

What correction? Well, platinum got a lot of press while it was rising. Less as it fell. Platinum gave back 20% in March.

Since then, it’s moved again. The reason we like it today? It just broke a key resistance.

Before we discuss the chart, there are two factors at work in the platinum market. Firstly, US$130 oil is making mining it more expensive. Secondly, it’s a precious metal. That scarcity of supply makes it a key alternative for the US currency. We don’t see the European Central Bank cutting rates anytime soon. No European money will be flowing into the greenback. But precious metals stand to see a bit of cash slosh their way.

Above all, the energy crisis in South Africa is still disrupting production.

Now…on the chart, there’s an obvious support line at US$1,830. You can see the double-bottom pattern between March and early May. The surge of buying following this has taken us past resistance of US$2,100. We see the renewed momentum taking platinum further up, at least as far as US$2,281. That’s where the double bottom began to form.

The MACD indicator is also clearly bullish. Platinum was oversold at the beginning of May, when the indicator fell below the zero line. Since then, it crossed back up. It hasn’t become overbought yet, adding weight to the new momentum.

Here’s a new indicator: the On-Balance Volume chart. It calculates a running total of volume. It basically shows whether money is flowing in or out of an asset. An upward sloping line indicates a good in-flow, and an uptrend in price. The OBV chart confirms for you that investors are coming back into platinum in a big way.

Where to from here? Well, it’s a clear sky above US$2,821, so we can only speculate. But if the price moves through US$2,281 (and we expect it to go that far at least), you could see a platinum move all the way to US$2500

Good investing,
Gabriel Andre

India Has 36 Billionaires

By Bill Bonner, May 26th, 2008

The oil market paused to catch its breath yesterday. Crude fell to $130, after hitting the $135 mark. Gold, too, took a step back – falling $10 to $918. Stocks, meanwhile, advanced a baby step – the Dow rose 24 points.

But we interrupt the news to bring you this question from a Daily Reckoning sufferer: “Why are you always so negative…so gloomy…and darned pessimistic?”

We would like to set the record straight. We are neither gloomy nor pessimistic. People who know us well say that we are often cheerful and fairly pleasant company. Even in adversity, we manage to keep a sense of humour. In fact, friends say we smile when bad things happen, provided, of course, they happen to someone else. And we often laugh gaily when reading the obituaries, as long as we don’t find our name mentioned.

Even as to matters financial and economic, we are far from gloomy. Quite the contrary. ‘Is the world going to hell in a handcart?’ Go ahead, ask us.

Glad you asked. The answer is ‘no’. Emphatically not. Definitely not. No question about it, no.

For most of the world’s people, things are getting better. A few years ago, billions of people – and about a third of the world’s landmass – was governed by dunderheaded communists. People stood in long lines to buy a tin of coffee…and then, when they got to the head of the line, the coffee ran out. The lucky few could save the money for 10 years to buy a car…and then wait three more years for it be ready for them. The car they got was the engineering world’s answer to the duck-billed platypus – awkward, ugly and frequently immobile. There were also purges, mass starvation, 5-Year Plans, and gulags. Tens of millions died prematurely; tens of millions of others would have preferred it that way.

Now, things are so much better. There are still communists and ex-communists running things in China and a few other benighted places. But even there, they aren’t quite as evil and stupid as they used to be. In fact, in some ways they are less evil and less stupid than people running things in the U.S. of A. The tax rate in Russia is only 13%, for example. Nor are Russian troops in Afghanistan or Iraq – trying to keep the locals in line; now the ‘peacekeepers’ sport the stars and stripes.

On the Forbes list of richest people in the world, the No. 5 billionaire is from India. In fact, India has 36 billionaires.

“Of those 36 Indian billionaires, 14 of them became billionaires just last year,” Chris Mayer tells us. “In other words, the number of Indian billionaires swelled by 64% in the space of 12 months…or a new billionaire created every month! India has the most billionaires of any country in Asia – even more than Japan now. And new millionaires are being created at a rate of 47 every day.

“The richest of them all – the fifth richest man in the world – is Lakshmi Mittal, worth $32 billion. He made his fortune in steel. Born in India, the ‘Carnegie of Calcutta’ now makes his residence in Great Britain, where he is that nation’s richest man.”

You may already have figured out where we’re going with this, dear reader. Yes, things are getting better in most of the world. People who were desperately poor a generation ago are now not so desperate. Wages are rising fast in the big, developing countries – Brazil, Russia, India and China. With higher incomes typically come better sanitation and better diets, which raise life expectancies. Then, of course, TV, automobiles, high-rise housing, electronic gadgets, suburbs and economists come along too – but nothing is perfect.

So you see, on the whole, things are improving; the world is becoming – if not a better place – at least a more comfortable place for most people. In this view, by the way, we are hardly alone. Most people have noticed.

But what about the U.S. economy? What about U.S. stocks? The dollar?

Ah…that…well…even as to these things we are optimistic. The United States needs a correction; we think it will get one. And here we part company with the vast mob of windy know-it-alls and kibitzers who make up our sorry trade. Most believe that if public officials merely yank on the right lever at the right time…or turn the right knob exactly the right amount…things will get better and better, forever and ever, amen.

We don’t think the world works that way. Instead, night follows day…no matter how smart we are. Mistakes are made…errors are punished…the world turns; sooner or later, every person ends in the grave…every generation is superseded by another one…every country disappears from the map…every enterprise goes out of business…and every boom ends in a bust.

Is that a gloomy outlook? Not at all; it’s just the way things work.

Hallelujah…otherwise, time would stop…the earth would stand still…and the whole universe would collapse in on itself, back to where it was before the Big Bang, as dense as a neo-con’s brain and as small as a tax collector’s heart.

Thank goodness, the United States is going into “corrective mode,” despite all the efforts of Ben Bernanke, the U.S. Congress, George W. Bush and every pundit, coast to coast, with an opinion.

Bill Bonner
The Daily Reckoning Australia

The Average Investor Makes Far More By Accident than by Fund Manager

By Bill Bonner, May 26th, 2008

This week’s news told us that good times are over. “For the time being, at least,” said the Governor of the Bank of England, “the ‘nice’ decade is behind us.”

Of course, just because an economist or a central banker says something, it doesn’t make it so. And when a central banker who is also an economist says something, it should be treated with the skepticism of an airline schedule.

“I am obviously biased, but I find it sad to conclude that the role of serious economists in financial institutions is very limited today,” said Han de Jong, Chief Economist at ABN Amro Bank to the Financial Times on February 21, 2008. “We are little more than clowns, whose purpose is to entertain clients….”

Mr. de Jong is too modest. Economists are essential to the financial industry. They distract the customers while the boys on the sales desks pick their pockets.

We say that not in contempt but admiration; the role of the financial industry – like the contemporary art market or like Las Vegas – is to separate the punters from their money. Economists help them get the job done.

This they did in the last two decades with a variety of gaudy theories. It didn’t seem to matter that the theories were contradictory and absurd. On the one hand, prices were said to move randomly – permitting them to ‘model’ risk and sell extravagant securities. On the other hand, private equity experts and fund managers pretended to know which way the ‘random’ movements would go; they claimed to be able to produce “alpha” – above market returns – on a such a regular basis they could charge “2 and 20” for it.

But while economists are usually wrong about things, the burden of the present essay is that Mr. King is right this time.

Last week, we argued that ‘alpha’ was a mountebank. The financial industry doesn’t often add much value, we pointed out. Instead, fair winds and convenient tides are what usually get investors’ little barks where they want them to go. Most of the results investors get depend upon setting sail at the right hour, from the right place, in other words, not in having a Wall Street hotshot at the tiller. Put an alpha-seeking whiz-kid out in a storm and he’ll sink along with everyone else.

In the 20-year period ’83 to ’03, for example, the price of oil barely moved. Sheep could graze peacefully in the Mideast, confident of being undisturbed. Now, everywhere they go, someone’s setting up an oil rig. The latest figures show oil exploration up 400% since 2000.

Almost a whole generation of investors got nothing from that greasy sector. Then, all of a sudden, in the following 5 years the roughnecks suddenly had money in their pockets and the wind at their backs.

Likewise, in America, you could have held residential housing for 100 years – from 1896 to 1996. You would have gotten nothing for your trouble but leaky roofs and cracked paint; prices rose only as much as consumer prices. Then, the next ten years, a tide of easy credit rushed into the residential real estate market; prices rose 70% in real terms.

Behind both these booms is a story too long to tell here. But the moral of it is simple enough. The average investor makes far more by accident than by fund manager. And here we venture a guess: of all the times and places in which a U.S. investor might hope to get a decent return on his money, this is not one of them.

But the beauty of capitalism is that people get what they’ve got coming – not matter what they think. NICE is an acronym for “non-inflationary consistent expansion,” according to Mr. King. It is his way of describing what other economists called the “great moderation,” a period so agreeable that they gave themselves credit for it. Macro economists believed they had finally mastered the art of central banking – so perfectly manipulating the credit cycle as to produce growth without causing the consumer price inflation that typically accompanies it.

If economic wizards were really responsible for the Great Moderation, it would be reasonable to think they could keep it going. Alas, they can no more sustain it than they can claim credit for it. What really happened, over the last 25 years, was a unique series of events and trends that now seem to have run their course. Labor rates fell as millions of new workers entered the modern economy. Now, even in China and India, salaries are rising fast. Logistical expenses declined as computers and just-in-time inventory systems were put in place; now inventories (and associated costs) are rising again. Outsourcing, globalization, deregulation, capitalization, securitization – all these trends helped keep prices down; now, all seem to have played themselves out, gone into reverse, or backfired.

Finally, the cost of money has fallen for the last 27 years. Sometimes it fell naturally. Sometimes it fell unnaturally, even grotesquely – such as when Alan Greenspan lent the Fed’s money at below the inflation rate for more than a year. Normally, cheaper money creates boom-like conditions. But normally, it comes at a cost: consumer prices soon begin to rise. As the economy “heats up,” the domino of labor costs falls over; workers are in demand so they ask for more money. Then, that domino knocks over consumer price stability; prices rise. Then, a whole line of dominos topples over. Bond investors run for cover, for example, forcing up interest rates. Then, the economy “cools down,” as the cost of money increases.

That was what was so nice about the ‘nice’ years. The dominos wouldn’t budge. Thanks to so many things working so hard to keep prices down, the normal process of self-correction broke down. As demand for labor increased, new, cheaper workers were found overseas. And even though the supply of dollars increased twice as fast as GDP, the domino with the CPI on it stayed right where it was.

Alas, those happy days are over. The Great Moderation is finished. This week, oil rose over $130 a barrel. T. Boone Pickens said it would hit $150 this year. And America’s core producer price index registered its biggest increase in 17 years.

Of course, the real level of consumer price inflation is probably far higher than the official numbers. The raw data suggest price increases closer to 10% per year than the 4% the US Department of Labor confesses. But the economists have their ways of making the numbers say whatever they want. In March, for example, the consumer price index was “seasonally adjusted” from 0.9% down to 0.3%. In April, wouldn’t you know it, another seasonal adjustment took the number from 0.6% down to 0.2%. We don’t know what the real number should be; no one does. But Mervyn King is right; the season has changed.

Bill Bonner
for The Daily Reckoning Australia