Italian Job

Although I believe that there should be some more runs in this bear rally (see my earlier post on Oct 12 of Bear Rally), now it may be a time to start to be vigilant and set one foot out of the door (or the finger on the trigger) to sell the risk trades whenever necessary. The market indexes are already close to level that I would feel comfortable given a margin of safely. But more importantly, Italy is the elephant in the china shop that the markets do not seem to see; it will be an Italian job to crash this party of bear rally. The yield on Italian bonds finally crossed 7%. Yet that is not the problem; this level of yield by itself would not necessarily lead to an immediate crisis. Yes, Italy has over 3 trillion Euro of debt, but the average maturity is about 7 years. So unless there is some urgent refinancing need, the yield itself does not cause any real problem. But if this level of yield is sustained for quite a while, there is no question we will see the end of Eurozone in the current form. 

So what are the solutions? The easiest solution is to have ECB buy an unlimited amount of Italian bonds. As a central bank, ECB has the obligation to do that, and this lender of the last resort is an effective tool to prevent banking crisis. Or Eurozone would have fiscal union. The two solutions are effectively the same, because the first solution would require eventual fiscal union to backup ECB. So the first solution is just to buy a bit more time before the final solution. Anything short of these will lead to the end of Eurozone in its current form.

But ECB is shirking from its obligations. Instead it is arguing convolutedly that it does not have this obligation (there is some hope that it will shut up and do it after a fair amount of crisis). Germany has eaten the cake of free riding the demand of other Eurozone countries, mostly PIIGS countries, in the last decade, and now it still want to have the cake too by asking for the full pound of flesh: all the money that it shoveled to PIIGS countries for them to buy German goods in the last decade. This is impossible, and will only lead to the end of Eurozone.

So investors should be on heightened alert (not necessarily actions yet) if they still want the limited percentages left on the table or they should retreat from their risk trade if they would rather have a more peaceful mind. From now on, the upside to volatility ratio will be much lower than what it was in the last month.

Would Eurozone by salvable? Yes, of course, contrary to many naïve perceptions even by professional investors. On a whole, it has few problems. Its debt to GDP ratio is reasonably low; it has little current account imbalance with the rest of world. All the imbalances are within its border. The sum of the current account deficits from PIIGS countries are almost exactly the same as the current account surplus of Germany over the last ten years. Overall, it is in the best shape currently in comparison to the U.S. and China. Its productive and intelligent people (as individuals, not government) always impress me (especially the Germans). It is a pity to see it being destroyed mainly by German Stubbornness (well they are famous for it). Note even if this case, Germans would not get a tiny bit more: these countries will leave Eurozone and default, thus bankrupt German banks. In addition, through currency devaluation, they will gain competitiveness overnight and Germans would lose its export market anyway. If you do not believe it, look at historical data; before the creation of Euro, most PIIGS countries never run chronicle current account deficit.

Why is that, you may ask? The reason is because once countries are in Eurozone, they have convertibility and stability of their currencies (which all become Euros), while losing independent monetary policy (interest rates) according to the impossible trinity. The fixed exchange rate with Euros also means they lose the important channel of (re-)gaining competitiveness through currency devaluation. It is way easier to gain competitiveness through external devaluation (exchange rate) than internal devaluation (cutting jobs and wages). When ECB set the interest rate according to the core/Germany, which is the main part of Eurozone economy, at a level that is too low for PIIGS countries, those countries experienced growth/housing bubbles on steroids (low interest rate). Investors’ expectation of eventual fiscal union within Eurozone also gives them false comfort that drives the long term yield of PIIGS countries down substantially. After the growth/housing bubbles collapse, along with the U.S. housing bubble, PIIGS countries’ economies are in shambles and their risk premium goes way up. The core countries also make sure that investors now realize the fiscal union may be just a wet dream, which pushes the long term yield of PIIGS countries even higher.

It is absurd that Germans are asking the pound of flesh. Any fixed income investors, a.k.a, creditors, are on the hook to evaluate credit risks before parting with their money. Once the money is parted, and the borrowers can and have the natural right to default. In defaults, the creditors are the ones who should be blamed, for being negligent about underpricing credit risks, instead of the debtors (This same absurd thing is also happening in the U.S. when zombie banks do not let go homeowners who would default).

It is also absurd for Europeans to ask emerging countries like China for rescue funds. They can rescue themselves easily; why ask anyone else. Further, have a huge amount of capital inflow from China would require a nearly equivalent amount of current account deficit against China, as required by the balance of payment identity (in a simpler form, it can be written as current account balance + capital account balance = 0). That would be a huge boost of employment for China, and condemn the PIIGS countries to eternal pain of soaring unemployment.

The bigger imbalance is between the U.S. and China. It would be an even more interesting show to watch how that would resolved. There, it is unlikely that China would have the political and military might to impose its will on a still superior U.S. Unless the U.S. is silly enough or being drugged by the currently evil republicans to do what PIIGS are doing (following German orders to give the pound of flesh), it is likely that China will face even worse outcome than Germany in that bargain. 

In sum, be on alert to get out or lighten up on risk trades soon.

Bear Rally

I suspect that we could have some sustained rally in the next couple of months. The US situation in Q3 is not as worse as feared (and it should not given that the main fiscal drag from reduced stimulus, e.g., payroll tax cut, won't come until the new year). Eurozone might find some temp bandit and would still have at least three months before the ultimatum on EFSF anyway. China has tried to signal support for its banks (none of its big 4 banks will go bankrupt anyway; that won't be an option for Chinese government, even though they are technically bankrupt, as in BOA and Citi situation). So it is possible this rally could run till after early November. So from a trading point of view, or from a professional money manager point of view, it might be wise to cover shorts and even load up a bit on risky high beta names with low bankruptcy risks. 

However, the bigger question is whether this is the end of this round of bear market? I doubt it. As mentioned in an earlier post, US recession is likely, given Republican's political interest. The Fed probably won't deliver a big QE3, if any (maybe 200 billion more bond buying). It is completely hopeless yet that Eurozone may eventually come up with necessary solution, but that will happen until things already become extremely dire. China has fiscal powder this year to boost up its growth (note that it ran budget surplus in the first half of 2011, like every prior year, which becomes budget deficit by year end, because of fiscal injection). But it should know that too strong a boost will only provide the precursor for an even more dramatic fall a few years down the road. Also, China's ill is nearly terminal (which may take decades to cure), because it is structural. No country ever has 33% or lower consumption portion of their GDP and no country ever has more than 50% GDP as investment. It has to fire tens of millions, if not much more, and then move them into service and consumption related sectors. It also has to resolve the issue of how to pay for the bill from massive misallocation of capital. If it is through financial repression as they did the last time, that will only make its economy even more imbalanced. The best solution may be selling all the SOEs and use the proceeds to build medicare, social security, and free education system. But since SOEs are the fat cows the monopolize Chinese industries and that the elite use to milk for their own pockets, that is politically infeasible.

So it is probable that the short sighted market will rally hard in the next couple of months, only find itself extremely disappointed at the start of next year. 

On a higher note, it is not impossible that the US will become much better than what it is now in 2013. If a Republican is elected into the White House, he is likely to renege on the campaign rhetoric that is only used to confuse people and make things worse. Once they have the rights to govern, unless they are extremist (they might as well be, at least up to now) who want to destroy the most powerful republic on earth, they are likely to raise taxes (especially capital gain and estate taxes), build infrastructure, and do some other right things such as reining in the big banks and financial industry.  Romney would be wise enough to do some of those. If Obama cannot do anything right and disgrace the most powerful position in the whole world, then it is not a bad idea that he gets booted. If Obama does get reelected, there is some chance he will finally show some teeth and do what is right. After all, most presidents only do what they strongly believe in during their second terms. So it is no inconceivable we could have a relative bull market in 2013. 

To end this note, I steal the following quoted lines from Mr. Paul:

"First of all, bank regulation is important even in the absence of bailouts. Don’t trust me, trust Adam Smith. Scotland invented modern banking; it also invented modern banking crises; and Smith, having witnessed such a crisis, favored bank regulations, declaring that

Such regulations may, no doubt, be considered as in some respect a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as or the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed."

So no one can be more eloquent than Adam Smith, the father of capitalism, about the issue. In fact, it would be a real pity to see a great country like the US being destroyed for the political interest of a few and send it to the class of Brazil in the 70s. Without such a great country to back them up, how would the moneyed elite keep their wealth. For now, they are free riding the American republic to the extreme. 2013 may be the time for them to make a choice. But whatever will happen then, we probably are destined to enjoy some dark days in the next year. That does not mean you cannot make money ;=). Bearish or bullish, there is always an angle to make money. Only the complacent lazy investors, which is the majority, hope for bull markets to make money.

Is technical analysis useful?

On October 3:

Charts are certainly great for short term predictions, not because they have any predictive power, but because everyone is watching and trading with them. So largely a herding effect. However, for longer term predictions, charts are much less accurate. If you back test any of the charts, you are unlikely to find anything there, unless you trade every day, which is again based on short term  predictions ;=), and the transaction costs will eat those profits alive.

I have not used charts for a long while now, but I should look more when it comes the time that the bottom might be near ;=).

More nuanced view about markets

On October 6:

What's your view on the property market in hong kong ? Do you think more serious adjustment is coming also ?

HK housing market is a bubble on steroids. It may not completely burst as long as mainland growth can hold up, but we probably will have some correction this winter and it may come back up if China floods everything with liquidity again. China still has some powder for now. But that would set up for an even big stage of the bubbles and will crash even hard when it burst within the next five years. HK economy will be in a big and long winter by then. However, that does not there will be no money made; one could retire once making it.

What's your view on when the stock market can be stabilized ? Or will it be haunted by the Greece sovereign debt crisis until it collapsed and started to default ?
 

Europe has a few months (say 3) to decide. One temp solution is to ask ECB to buy unlimited amount of PIIGS debt. That can probably delay the resolution by another 6-12 months top and is not a long term solution. In that case, people in those countries will rebel and default and leave Euro zone, and ECB would still need Germans to recap because it has little equity. And Germans still have to recap their own banks. Some say it is just loading the explosives in the can and then kick the can down the road. The long term solution, if they still want the one Europe dream, is fiscal union, like the US. But that is not possible in near term given the very long approval process (take years), and that average Germans do not want to do that at all. So that is the biggest explosive right now.

Market won’t drop in straight lines. So as I mention in earlier email, markets might stabilize or even rally, especially given that the Fed may send another 200 Billion QE out after relatively miserable Q3 numbers are announced at the end of October and start of November. But the US will likely have a recession; republicans have tried hard to make the economy bad. They now hope for a recession in order to get in the White House. There is a very high correlation between a recession 6-12 months before election and the incumbent president being ousted. This is the last moment before their potential success, they will not give ground. They are effectively committing treason in the last couple of years for their own political gains. In a cynical way, you may not fully blame them, because the man who hold American presidency, the most powerful position in the world, did nothing to stop them. Instead, he is complicit in their crime. If these guys are not doing things like this, the US would have been in much better shape. 

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Some Friends wrote back and said that they agree with me. They believe  everything is a doom for the near future. I might beg to differ on the latter point. There are still a lot uncertainties and even though we could have a baseline scenario, the bi- or tri-mode nature of the near future outcomes means we need to be flexible in terms of our predictions. Just from a simple trading point of view, you could short into the market by taking a bearish view and markets eventually go down much more. However, if in between there is a bear rally, it could cause so much pain that you cannot hold the position. Since I have no time recently, I am simply out of the market for the most part now, because if you read one of my earlier post, I predicted this would have been a slowly downward trend market with lots of volatility (which most do not enjoy). So on the surface you might get it that this will be a bear market, and you thought everything is easy, but markets and the situations going forward are actually much more nuanced than that (Well, that gives you one  more )reason to read my blog, doesn't it?).

To follow up on the above point, also on October 6:

I think the EU solution could have many alternative outcomes than just a singular solution of printing a lot of money. That is the usual mistake people have made with the Fed, hence the false inflation scare last and this year. Also, China is not really that hand tied; they still have enough powder to deploy. So I am actually not necessarily that bearish on China for the time being. But if they do not do it in the right way to start the transition, they will lose the last bit of wig room and the crash from next crisis, say a couple of years from now, could be much bigger. So the situation might be much more nuanced than simply saying it is all downhill from here. 

lucky on a very short term view

The last two emails were actually included in my email sent to a bunch of friends on very short time view. I am lucky to be right on this very short term view as well. In HK for example, the share prices have dropped to May 2009 level. A lot of savings for people who have kept money in dry powder.

On Tue, Sep 27, 2011 at 10:25 AM, Xi Li <xli5@hotmail.com> wrote:

Hope you have enjoyed some market action so far. I warned some fellow members about this coming slaughter, the earliest in April when people like Yang Kun, Xiao Xiaofeng, and Guan Yu were together at dinner with some friends from CIC (The CIC). It will be mostly volatility + downside in the next few months. Now is still not a bad time to get out of position, especially with this current unavoidable technical rally. These are updates on my blog http://xlpartners.blogspot.com/. Had no time to write a blog so simply cut a couple paragraphs from email communications in the last few months to share.

Some clarifications on longer term forecasts

In response to people’s question about point 4 in long term forecast, I wrote:

China faces a fork in the road when it slows down. The entrenched interest may keep or grab more wealth, but that will make China either a Latin American countries in the 70s with government terrorism or have a revolution. Or the entrenched interest may step back and start the inevitable transition process and share some of the wealth with the rest of Chinese people. Now the GDP growth is 9-10%, of which investment grow at 13-14% whereas consumption grows at about 7%. In transition, say investment grows at 0% and consumption at 7%, that would make the overall 3-4% GDP growth. So if consumption is largely growth at similar speed like before, people would not notice as much on that aspect. The pain though will still be inevitable because China’s problem is structural. All the resources, especially people, will have to be relocated to service from export and investment driven industries. So lots of people will lose their jobs. The transition would need government monetary and fiscal policy to help.

In response to people’s question about HK vs. Mainland housing bubbles, I wrote

Yes, both will suffer in the longer term. It may be a 10 or more year downward adjustment. HK could have big downward adjustment because it is not only exposed to Chinese economic growth, but also US interest rate. So you could say that the real interest rate today in China is 0; both normal interest and inflation rates are about 6%. But the real rates in HK is about -4%: its exchange rate system require a peg of nominal rate to the US at 0% (due to the impossible trinity concept that I discussed at the BCIC meeting last Nov) while having about 4% inflation rate. So it is a housing bubble on steroids and could even worse than China. When either China slows down or US recovers some, its housing market may have worse adjustment than China. Of course if a lot of Chinese money gets scared in mainland, they may escape to HK to buy something here. That might provide some support from below.

On the money so far and longer term (5 year forecast)

Setp 8

To share my two cents about the near term, we will have sharp ups and downs. Some actions (QE3 or 2.5) from the Fed at the end of both Sept and Oct will probably hold the market around the current levels (could be up by more than 10%) till Nov. However, we are likely to have a recession toward the end of the year or at the start of next year, and that is when the big market tank will likely happen. I also attached my longer term predictions (5 year) at the very end. If we are patient enough, most, if not all, will pan out in a few years.

Aug 4

If you still remember that I mentioned that we will have another deflation scare latter this year at our dinner during your visit to Boston this spring, it is now in full force. It will probably last at least until after the third quarter when the Fed could have more political capital and will to do QE3 (The risk of US severe recession is still not too high though). In the meantime, which is still at least a couple of months ahead, we will have rocky downward market with sometimes sharp rallies. We should see a repeat of risky asset rally (globally) when the Fed finally comes out with QE3 again. It is opportunity to be had when that happens. 

Longer term forecast

n  China will face sharp slow down in growth in five years (say from 10% to 3%) for many years to come

n  Related emerging markets and commodity producers will suffer as well.

n  HK’s housing price will drop substantially

n  Chinese people may not suffer in their satisfaction

n  The world will not come to an end with the slowdown in China’s growth

n  Eurozone will not survive in the current form

n  The U.S. will become stronger in relative terms if it can get the political act together

Sorry for the absence

Sorry for having missing for the last few months. The last few months have been quite busy for me. It looks like to continue this way in the near future. I will try to post more whenever I get the chance.


My view has changed  since late October last year. At a meeting of Boston investment professionals early last November, I have already argued for the bull case in equity markets. The double dip risk is not there any more, at least not that noticeable. 

Then I also mentioned that there will be some large downside volatility in Chinese markets in particular when China starts to be pressed to fight inflation, mainly from its stubbornness to largely fix nominal exchange rate. I will give another five years of high growth for China and then its growth rate is likely to drop much below 5%, say 2-3 %, from there. That does not mean that Chinese people will suffer that badly in living standard, because the consumption related sector should have higher growth rates than the overall GDP. If Chinese governance still keep the real interest so low for too long, China will have an even bigger asset bubble, e.g., another doubling in housing price. This is probably the most likely scenario. It is politics, not economics, that determines policies. So this may be a period to speculate cautiously and make a few bucks. But then the fate of future growth rate will be even more miserable, maybe for decades to come. The demographics will add a huge drag to the growth rate too. 


Housing will probably bottom out this year in the U.S. It may not take off, but capital loss risk will become much smaller after the summer. I sold my house in 2007 and have not bought one since. I will think about buying now. 


As long as emerging markets keep enjoying higher growth rates than the developed markets, capital will keep flowing to where the growth rates are higher. However, in the short term, EM probably will be forced to fight inflation, because they generally try to keep exchange rates a bit too low to gain export edge. That tightening, which is completely involuntary, will drag the market momentum that were trying to go higher. In the medium term, they are still attractive. In the longer term (e.g., beyond five years), they are vulnerable because they are probably all too dependent on the China story (think commodities), and will have trouble adjusting when China really slows down sharply in its GDP growth.