When to set up the same trade that I described to start on Jan 1 last year for last year

Since I have been telling people about a potential rally in risky assets from last December that could last till the end of the February, due to the temporary extension of US payroll tax cuts to the end of February, the best time to set up the trades that I mentioned as performing extremely well last well may be some time close to the end of February, unless some disaster in Eurozone erupts. Also, if the US Congress extend the same cuts longer, the markets could have even longer a relatively calm period.

Is there anything to do in the meantime? Are those trades the only thing one can do by believing my longer term predictions? Yes, of course. Plenty of them. As I mentioned a few times in the past, "Only the complacent lazy investors, which is the majority, hope for bull markets to make money."

Who is the most novice investor I refer to in my prior post?

My dad. He is about 75 and a retired professor. He has gambled invested in Chinese stock markets for a long time but I do not think that he made any money from this effort. Throughout 2011, I strongly urged him not to invest in stocks but put money in the highest interest yielding saving instrument he could find or Chinese T bond. Since I have not been back to mainland Chinese for almost six years now, it is difficult for me to check his actions. But I did learn that he is not heeding my advice even if I have been trying all the means to rein him in. When I finally met him this last December, he has lost a decent sum this year, instead of making money if he has followed my advice. It made me realize how biased human behavior could be. Even though it does not mean you can necessarily make money from market inefficiency, the markets are surely not efficient, to the smarter minds!

Review of 2011 and Preview of 2012

Everyone is writing a review of 2011 and a preview of 2012. So I am obliged for one as well. How do my predictions fare this year? Here is what I predicted to be happening in the next five years since late 2010.

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

Review: So Chinese stock market started from around 2800 and reached more than 3000 and ended at around 2200. Chinese property prices (new housing only) are reported to have dropped as much as 20-40% from peak in big cities like Beijing and Shanghai.

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

Review: The starting and ending points of some of the representative countries are: Argentina 3600 to 2400; Australia 4800 to 4100; Brazil 70000 to 57000; Russia 7000 to 5700; Note that for many of these countries, the returns would be much worse on USD terms.

n  HK’s housing price will drop substantially

Review: HK’s housing prices have already dropped by about 10-15% from peak. Its situation will be somewhat better than mainland given that its substantial wealth fund and mainland outflows may cushion some eventual fall.

n  Chinese people may not suffer in their satisfaction

Review: Although I do not have the wage growth numbers yet, but this may be the first year in a long time that Chinese wage growth is far greater than GDP growth.

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

Review: We still have to wait for this one in a few years of time, given that China has just started the first bout of real slowdown.

n  Eurozone will not survive in the current form

Review: Stoxx Europe 600 dropped from 285 to 240. Euro dropped substantially (though Germany has strong incentive to keep Euro in the hopes that other countries would still repay their debt in Euros, which may make Euro / German Mark a strong currency eventually given Germany’s export prowess).

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

Review: SP500 dropped from 1280 to 1260, the least drop probably among any of the larger markets.

Market timing review (only turning points):

April 10: Predict deflation scare later in the year, Hang Seng at 24k

August 4: Deflation scare is in full force, Hang Seng at 22k

October 12: Bear rally, Hang Seng at 18k

November 9: Italian job, Hang Seng at 20k

Currently, Hang Seng at 18.5k

My guess is that people are far more interested in 2012 previews. So here they are. But remember whatever you fail to act on my advice is real money left on the table by you. So think about that when you are trying to decide about the new year. The longer term themes will play similarly like 2011, though as usual large volatility is guaranteed.

US likely will outperform in terms of economy. As I mentioned in earlier posts, I envision the US may be much better in 2013. However, recently Obama has finally become less ineffective and his narrative is cornering Republicans who are fighting for the primary right now and thus have more chance to split and criticize each other. Republicans will have a hard time because Obama does not need to be really effective to turn the table on them. For example, it is difficult for them to reject tax increases on the rich while also rejecting payroll tax reduction extension for average Americans. So the recession risks in the first quarter would be much smaller than what I assessed before. Unless Europe really has its tailspin, and maybe we have a simultaneous big negative shock in China (which may still be unlikely given that this is the last transition year), then the US may be pushed straight into recession. Otherwise it may still have zero or positive growth.

Europe will finally have one or two small periphery countries defaulting (and maybe simultaneously leaving Euro zone). The final outcome for larger countries like Italy and Spain may still be delayed into 2013 or 2014. Pay attention to the refinance funding hump around March. So some rallies may happen at the start of the year, due to encouraging US data, only being crushed at or around March.

China is crippled. It will not have enough powder to ignite yet a huge bubble and many have finally come to terms with how insurmountable are the issues related to China’s imbalanced growth. But it is unlikely to have GDP growth collapse this or the next year. The first trick the government would try is to speed up the low income housing projects. But that is unlikely to make up the hole left by the current boom in commercial and high end residential real estate. Then the government may yet revert back to the prior real estate booming sectors again, because unless a crisis already crushed a big section of the economy, the least politically difficult path is to keep the status quo and the leadership is unlikely to start to solve the root cause of the problems in China.

Many of the commodity exporters and emerging markets would still have enough powder to survive a couple of more initial shocks in the next couple of years. But in the longer term, they will also experience a regime change in terms of their growth.

So in conclusion, the world has grown in relative peace and prosperity under the current model for 20 years. The resulting imbalances, in particular the imbalanced growth between US and China and between core and periphery Europe and the sharply increased wealth disparity in most parts of the world, are being pushing to extreme. Most people have false hope that the world could yet quickly revert back to its prior growth trajectory after a brief financial crisis in 2008-2009. What they fail to realize is that until these imbalances are resolved, the forgone prosperity won’t come back easily. Yet no adjustment to resolve the imbalances is painless.  What the world is currently suffering from is the pain due to these adjustments. So for people who are interested in the end of this painful period, remember that until all the painful adjustments are done to the issues that I pointed out above, we won’t see the end of pain. We are only partly through the adjustment in Europe, whose internal imbalance is small in comparison to that between China and the US, and this latter imbalance is just starting to be resolved. In this environment, taking the appropriate asset allocation strategy will avoid you sharp losses and leave you far ahead.

Unfortunately, among the people or funds that I know or read about, I still mostly see confused souls that have no correct sense of direction. This is not surprising given the deeply seated human behavior bias of overconfidence and the general ignorance of the dominant majority of investors, including professional investors. Even some of the most novice investors I have met could still be so convinced that they are going to do much better than the market and the rest of people. This is not because I want to pull ranks or past prediction record because I strongly believe the extent of a person’s understanding of the world cannot be measured by his/her rank, position and title, mathematical and programming and writing skills, the length of experience and age, or past track record (even though the society is in general much more prejudiced and ignorant on this aspect). Maybe they should learn to ask for my help? After all, if my blog is a valuable information source, it should not be free forever. Well, time is what is in the short supply here.

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 ;=).