May 21st, 2014
X-Factor Report, 18 May 2014
by Lance Roberts, Streetalk Live
There was quite a bit of excitement at the first of the week as the market set a new closing high. However, what happens between Monday and Friday is often little more than "noise" which elicits emotionally driven investment mistakes more often than not. This is why we use weekly analysis to effectively separate the "forest from the trees." As such, the intraweek market action failed to create any change in the market consolidation or topping process that has been in place since February.
Last week I posted the following chart that shows the two most likely paths of the markets over the intermediate term.
I have added the current bullish trend line which has acted as short term support since April. What happens over the next week or so will be critical as to the direction and trend of the overall market going forward. It is important to remember that it has been an extraordinarily long time since the markets have experienced a 10% correction. With each passing week the odds of a 10%, or greater, correction occurring increases.
China - A House Of Cards
Since March of 2013, I have been consistently suggesting that exposure to emerging markets, and particularly China, should represent a ZERO weight in your portfolio. The reason is simple - emerging markets are SOLELY dependent on the economic strength of Europe, Japan and the United States for their existence as they are primarily exporters of products.
With the U.S. sputtering along economically, Japan on the verge of its next recession along with the Eurozone, there is little reason to be invested in countries that have the most at risk.
China, however, is a particularly bad investment. The economic statistics produced from the government of China are lies. There is no sugar coating this reality.
Think about this for a moment. 30 days after the end of each quarter the Bureau of Economic Analysis (BEA) reports an initial estimate for U.S. gross domestic product. During the next 60 days, it is revised twice more as more data becomes available. Then a year later the data is revised a final time.
China, on the other hand, reports its economic data 15 days after the end of the quarter and it is NEVER revised.
Considering how many of you current distrust the economic reporting of the U.S. government, why on earth would you believe that ANY of the data coming out of China is anything more than propaganda?
However, let's assume for a moment that the economic data reported out of China is accurate. Then you have to ask yourself about where that economic growth came from. When you build entire cities in which no one lives, build railroads that are unused, massive shopping malls that are empty, and venues that remain vacant - you can fabricate economic growth. However, it is economic growth that is as empty as the ghost towns that were constructed.
It should not come as a surprise that eventually a house built of cards eventually crumbles. In this case, it is China's house that is very likely on the verge of collapsing. Via Reuters:
"The combined economic output of China's provinces has long exceeded that of the national level compiled by the National Bureau of Statistics, raising suspicion that some; growth-obsessed local officials have cooked the books.
Analysts at Bank of America/Merrill Lynch estimated that the weighted average of provincial real GDP growth rate in the first quarter was 8 percent, down from 9.5 percent in 2013.
Chinese leaders have recently set new standards for local officials, stressing that their performance cannot be simply based on regional growth rates, but should include resource and environmental costs, debt levels and work safety."
So if these are the 'locally' reported data - and they are this bad - just how bad is the growth? And just how bad has it been for years as perhaps this is the normalization to reality that so many China realists have been expecting (and China bulls denying).
Here are some stats to think about if you are betting on China:
- Over the next five years, China's leadership encouraged "new measures" that included widespread property tax changes that released huge amounts of agricultural land for housing development.
- State-owned-banks were commanded to increase lending in just five years by $15 trillion, twice the entire Chinese annual gross domestic product (GDP). As a result, housing prices increased in major cities like Beijing from an average of $1,150 per square meter in 2005 to $11,400 per square meter today. Condos that would have sold for $3,500 in 1994 are now listed for sale at $833,000. Can you say housing bubble?
- Over the last six months, real estate demand and prices have been contracting faster in cities beyond the nation's relatively wealthy "first-tier" metropolises of Beijing and Shanghai.
- According to the Securities Times newspaper, housing developers in the industrial city of Hangzhou cut prices this week by an average 19% in a scramble to sell about 120,000 newly-built apartments.
- The current inventory of new, unsold units now exceeds the total number of housing units offered for sale in Beijing and Shanghai combined.
- The borrowing binge in China was not just restricted to state-owned lenders; approximately $3.5 trillion in private loans made to individual speculators at up to three times the interest cost of bank borrowing.
- Many of these loans were made to shady business operators who bought coal mines to speculate on the growth of electricity demand. But most of those loans became insolvent as the economic slowdown caused the price of coal to be cut in half over the last year.
- Chinese banks over the last six months have been forced to borrow large amounts of short-term money as income from their loan payments have slowed.
- According to Beijing's State Administration of Foreign Exchange, at the end of 2013 China had foreign liabilities of a stunning $3.85 trillion; roughly 40% of total GDP. The bulk of those liabilities consist of $2.32 trillion of highly illiquid foreign direct investment for plant and equipment. Another $374 billion is foreign investments in China's stock and bond markets that could be sold at any time. But most investors are unaware that money is also locked up because China's qualified foreign institutional investor program has strict limits on the size and frequency on withdrawing money from the country.
- The contraction of HSBC/Markit Purchasing Managers' Index to 48.3 during China's biggest annual holiday seems dire when coupled with the PMI's Employment Index fall for a fourth month in a row to 46.9, its lowest point since the depth of the financial crisis in February 2009.
- Over the last five years, Chinese central planners drove GDP per capita from $2,204 to $3,348, the fastest expansion of any large economy in the world.
It is clear that the Communist party leadership would love to continue inflating China's economic bubble with more lending. However, with banks facing massive loan losses and scrambling for short-term funding just to survive, central-planners seem powerless to prevent China's economic bubble from bursting.
Again, I reiterate, get out of Emerging market investments, particularly China, and focus on domestic investments. If you want China exposure buy McDonalds, Subway, Pepsi, Yum or a multitude of American companies that do business in China. You will at least survive the eventual collapse in China when it comes. Furthermore, as shown in the chart below, over the last 4 ½ years there has been no reason to long China anyway.
Interest Rates Trending Lower
Two weeks ago in this missive I wrote:
"However, with the Fed now extracting their support, economic strength waning and deflationary pressures still prevalent - it is unlikely that rates will rise anytime soon. The recent decline in interest rates, as we have been predicting would occur since last May when I first suggested a 'bond buying' opportunity, has now gotten back to the bottom of its current trading range."
"Without real signs of a strengthening economy, as shown by very weak factory orders last week, combined with Fed extracting support from the markets, rates will decline further."
Last week, rates broke solidly through the bottom of that trading range confirming the rotation by investors back towards "safety" and out of "risk" as the Federal Reserve's support wanes.
As I discussed recently, there is an ongoing belief that the current financial market trends will continue to head only higher. This is a dangerous concept that is only seen near the peak of cyclical bull market cycles.
When markets are under attack money rotates out of "risk" assets and into "safe" assets. I have addressed several times recently that the internals of the market were beginning to deteriorate which suggests that this particular leg of the bull market cycle may be near its conclusion. This point was reiterated yesterday by David Tepper who manages the $20 billion distressed debt fund Appaloosa Management:
"I am nervous. I think it's nervous time. While the market is probably okay, it's getting dangerous. I'm not saying go short. Just don't go too friggin long."
The Central Banks are now in "Coordinated complacency...the market's kind of dangerous in a way. I think the ECB...they better ease in June. I don't know how far they are behind the curve...We are a fairly leveraged world...I'm not so keen about deflationary forces. I'm more worried about deflation than inflation... First of all, I don't know how to feel it out. I've never lived through it.
If the ECB does this thing, the market's probably OK. If they don't do this thing, it's not OK."
Whether or not you like David Tepper is irrelevant. He has continually suggested being long stocks as long as the Central Banks were injecting liquidity which has been the right call. With the Federal Reserve now extracting that support, stocks have stagnated and risks have risen. His call of being "nervous" is the right one and interest rates are likely confirming his call.
The point here is that while the current trends can last longer than reasonably believed, which is why we currently remain invested in the markets; it is inevitable that things will change. The problem for most is that by the time they recognize that the underlying dynamics have changed it will be too late to be proactive, only reactive. This is where the real damage occurs as emotional behaviors dominate logical processes.
Bernanke Admits That We Are In A Liquidity Trap
In July of 2013, I penned an article entitled "What Is A Liquidity Trap And Why Is Bernanke Caught In It?" If you don't know what a liquidity trap is, take a moment to read the article where I explain it in detail.
The crux of the article was that despite a lot of "jabber jawing" by the Federal Reserve they are going to be unable to increase the Fed Funds rate, or allow interest rates to rise substantially, for the foreseeable future. The problem is that with extremely weak economic growth, a financial market where all return assumptions are based on a low interest rate structure, and an overleveraged consumer; any increase in borrowing costs immediately leads to an economic contraction.
With Bernanke now retired from the Federal Reserve, he can speak the "truth" for a nominal per dinner cost of just $250,000. (Not bad work if you can get it.) Reuters reports an account of one such dinner speech given to private wealthy investors:
"Ben Bernanke has been clearer than he ever was as chairman of the Federal Reserve on his expectations that easy-money policies and below-normal interest rates are here for a long time to come, according to some of those in attendance.
Under his direction, the Fed took the fed funds rate, its key policy lever, to near zero in late 2008 as the financial crisis raged. The central bank has held it there ever since in a bid to stimulate a stronger rebound in the world's largest economy.
At least one guest left a New York restaurant with the impression Bernanke, 60, does not expect the federal funds rate, the Fed's main benchmark interest rate, to rise back to its long-term average of around 4 percent in Bernanke's lifetime, one source who had spoken to the guest said.
Another dinner guest was moved when Bernanke said the Fed aims to hit its 2 percent inflation target at all times, and that it is not necessarily a ceiling.
'Shocking when he said this,' the guest scribbled in his notes. 'Is that really true?' He scribbled at another point, according to the notes reviewed by Reuters."
As I stated last year:
"For the Federal Reserve they are now caught in the same "liquidity trap" that has been the history of Japan for the last three decades. With an aging demographic, which will continue to strain the financial system, increasing levels of indebtedness and poor fiscal policy to combat the issues restraining economic growth it is unlikely that continued monetary interventions will do anything other than simply foster the next boom/bust cycle in financial assets."
The chart below shows the 10-year Japanese Government Bond yield as compared to their quarterly economic growth rates. Low interest rates have failed to spur sustainable economic activity over the last 20 years. It is unlikely to foster real economic growth in the U.S. either.
As I stated previously in "What Inflation Says About Bonds & The Fed:"
"The real concern for investors, and individuals, is the actual economy. There is clearly something amiss within the economic landscape and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get themselves out of the 'liquidity trap' they have gotten themselves into without cratering the economy, and the financial markets, in the process. As we said recently this is the same question that Japan is trying to figure out as well."
Should we have an expectation that the same monetary policies employed by Japan will have a different outcome in the U.S? More importantly, this is no longer a domestic question - but rather a global one since every major central bank is now engaged in a coordinated infusion of liquidity. The problem is that despite the inflation of asset prices, and suppression of interest rates, on a global scale there is scant evidence that the massive infusions are doing anything other than fueling the next asset bubbles in real estate and financial markets.
The Federal Reserve is currently betting on a "one trick pony" which is that by increasing the "wealth effect" it will ultimately lead to a return of consumer confidence and a fostering of economic growth? Currently, there is little real evidence of success.
Have a great week.