This week’s report has been compiled on airplanes and in airport lounges spanning New Orleans, Washington, Johannesburg and Cape Town. And similar to the turbulence experienced on some of my flights back home, financial markets have also had a real rollercoaster ride.
Before highlighting some thought-provoking quotes from market commentators during the past week, let’s briefly review the markets’ actions on the basis of economic statistics and a few performance charts.
The economic highlight (or perhaps lowlight) of the week came in the form of existing home sales falling by a whopping 8%, which was much more severe than expected and represented the largest drop on record. As if that was not enough, Merrill Lynch, the US’s largest broker, reported a loss for the third quarter and said its write-downs for bad mortgage loans and related securities were almost $8 billion, well above the firm’s own previous estimate of just a few weeks ago.
After the housing report, a 25 basis point rate cut at the FOMC’s meeting next week became fully priced into the market, and talk moved to the possibility of a more drastic 50 basis point reduction. Canadian-based BCA Research put it as follows: “Credit markets are not yet out of the woods, which will keep the Fed biased toward easing.”
The pertinent question for investors is: what are the chances of the US economy going into a recession (i.e. two consecutive quarters of negative GDP growth) over the next few months? (Also see my recent posting entitled “Does the Big R (= recession) lie in store for the US?”)
WEEK’S ECONOMIC REPORTS
Source: Gold Seeker Weekly Wrap-Up, October 27, 2007.
This week’s economic highlights include Consumer Confidence on Tuesday, GDP, the Chain Deflator, Employment Cost Index, Chicago PMI, Construction Spending, and the FOMC policy statement on Wednesday, Personal Income and Spending, Core PCE Inflation, Initial Jobless Claims, the ISM Index, and Pending Home Sales on Thursday, and Factory Orders and October’s jobs data on Friday.
Global stock markets
Global stock markets ended the week on a high note after declining steeply on Wednesday morning after the announcement of Merrill Lynch’s shocking quarterly results. On the other hand, better-than-expected earnings from Microsoft contributed towards markets closing strongly on Friday.
Mature and emerging stock markets alike registered gains for the week as a whole, with the Japanese Nikkei Average and the Shanghai Composite Index being the only exceptions. The star performer, however, was the Indian BSE 30 Sensex Index which recorded a new all-time high after advancing by 9.6% during the week.
Global fixed-interest and currency markets
Global bond yields were lower for the week as investors focused on slower economic growth. The rate of the US 3-month Treasury Bills, however, edged higher on the back of another round of credit concerns.
The US dollar Index fell to a new record low as more poor economic data supported the view that the Fed will cut interest rates by at least 25 basis points next week.
The week belonged to energy and precious metals, with crude oil recording an all-time peak of $92.2 and gold bullion hitting a 28-year high. Concerns that oil supplies will fail to meet demand during the winter heating season and tensions in the Middle East propelled the oil price skywards.
The rise in the oil price, together with a declining dollar, boosted gold as investors again focused on flight-to-quality issues. Silver, having lagged gold and platinum for a while, played catch-up with a 4.7% gain for the week.
As was the case last week, industrial and agricultural commodities were mixed as investors weighed up the positive effect of a plunging dollar against the negative implications of weaker economic growth.
Now for some words (and pictures) from the investment wise to help navigate through the markets’ cross-currents.
Doug Casey: Larry Lindsey’s unbelievably candid speech
“Larry Lindsey, Dubya’s ex-economic advisor, gave an unbelievably candid speech yesterday at the New Orleans Investment Conference. He basically said that the Fed, the banks and Wall Street had created the enormous problems that we face today and that it was ‘look out below’ time. In answer to a question from the audience, he also admitted that he didn’t believe, or use, the government CPI numbers, and said that businesses shouldn’t be doing it either!
“After his speech, I had a chance to talk to him one on one before the rest of the thundering hordes arrived. The most interesting point of all was that he said he was a ‘gold bull’ because of all the inflation in the system. He said that twice, with no solicitation from me, although we had been discussing gold market price management prior to that. I’m sorry that you weren’t there to have heard all this for yourself, as it was an ‘Alice in Wonderland’ experience. He confirmed every reason that I have given as to why you should be out of equities and bonds, and into gold …”
Source: Doug Casey, Casey’s Daily Resource Plus, October 25, 2007.
Asha Bangalore (Northern Trust): Recessionary periods ahead?
“On a quarterly basis, the Chicago National Activity Index was -0.31 in the third quarter, marking the fifth consecutive quarterly drop of the index. Historically, sequential declines of this nature are associated with recessionary periods.”
Source: Asha Bangalore, Northern Trust, October 23, 2007.
BCA Research: Credit markets – not yet out of the woods
“The subprime debacle is rearing its ugly head yet again, sending investors scurrying for safe havens. The 2-year US Treasury yield and the 3-month Treasury bill rate are falling, while indexes of subprime mortgage security prices have plunged anew. Many had hoped that the worst of the fallout from the subprime mess was over. However, fresh ratings downgrades of mortgage-related debt, more bad housing news, and earnings disappointments from some major banks, reminded investors that the risks remain elevated.
“Investors are also skeptical that Wall Street’s $100 billion “superfund”, designed to avoid forced asset sales by Special Investment Vehicles (SIVs), will help the situation much. Until housing bottoms, there is no respite for subprime-related debt. Bottom line: Credit markets are not yet out of the woods, which will keep the Fed biased toward easing.”
Source: BCA Research, October 22, 2007.
John Mauldin: The $100 billion Superfund to the rescue?
“… Citibank, Bank of America, and JP Morgan Chase announced they intend to set up an $80 – 100 billion fund which would buy the ‘good children’ of Special Investment Vehicles (SIVs) that are in trouble. As illustrated below (from the Wall Street Journal), they will offer to buy an asset (one of the good children) for $0.94 plus a 4% note. There are about $400 billion in SIVs, so if they can actually raise the money, it would be a large chunk of the market.”
“Mike Shedlock came up with the great line that the Superfund is really a fund that allows the banks to postpone marking to market. Don’t ask what the paper is worth, and don’t sell it so we don’t have to mark down our own paper.
“… the Superfund puts a bottom price to the market. Pardon me for being cynical, but I bet that $.94 plus a 4% note is a mark-down the big banks can live with. It also is an opportunity to make a nice profit on holding the good children to maturity. The Superfund does not solve the problem of what to do with the subprime debt. Those losses are going to find their way onto the balance sheets of the banks eventually. But what it does do is buy time. Instead of having to take all that debt (both good and bad) from day one, it strings things out.”
Source: John Mauldin, Thoughts from the Frontline, October 19, 2007.
Jeremy Grantham (GMO): US house prices will decline
“Recognizing bubbles is held to be hard: ‘To spot a bubble in advance,’ said Greenspan, ‘requires a judgment that hundreds of thousands of investors had it all wrong.’ Greenspan has since contradicted this ridiculous comment many times when describing investor herding and irrational behavioral markets. And his great 2000 bubble, partly indeed his creation, peaked 65% higher than any previous market. Not only did it look like a Himalayan peak, but statistically it was a 3-standard deviation, 100-year event. Far from being hard to spot, it was impossible to miss. The current housing bubble (see Exhibit) was also easy to see.
“As for Bernanke, in October 2005 he claimed that advancing house prices merely ‘reflected strong economic fundamentals.’ Also in 2005 and slightly less cavalierly (but only slightly), he said on CNBC, according to The Economist, ‘We’ve never had a decline in housing prices on a nationwide basis. What I think is more likely is that house prices will slow, maybe stabilize.’ Look at the Exhibit for a second. The market was deep into a 40-year (2-standard deviation) bubble based simply on a long and relatively reliable price series and its volatility. What was he thinking? Do he and his assistants not look at long-term prices, or has the mean-reverting nature of house prices not yet revealed itself?”
Source: Jeremy Grantham, GMO’s Quarterly Letter, October 2007.
Bloomberg: Merrill Lynch Reports Loss on $8.4 billion writedown
“Merrill Lynch & Co. reported the biggest quarterly loss in its 93-year history after $8.4 billion of writedowns, the most by any securities firm. The third-quarter loss of $2.24 billion, or $2.82 a share, was about six times higher than the New York-based company estimated on October 5. Merrill wrote down the value of subprime mortgages, asset-backed bonds and loans to finance leveraged buyouts, and Chief Executive Officer Stanley O’Neal said in a statement today that he is ‘working to resolve the remaining impact from our positions.’
“Merrill fell as much as 3.1 percent in New York trading and now ranks as this year’s worst performer among the five largest investment banks, after O’Neal misjudged the severity of the decline in the credit markets since July. Investors who lauded the 56-year-old CEO for chasing higher returns now question his management as the firm became the biggest underwriter of debt securities backed by subprime loans.
“’We’re very disappointed,’ said Rose Grant, who helps manage about $2 billion at Eastern Investment Advisors in Boston, including Merrill shares. ‘I don’t think Stan O’Neal will step down, but you do have to look at top management and wonder why they didn’t know the extent of this loss.’”
Source: Bradley Keoun, Bloomberg, October 24, 2007.
Eoin Treacy (Fullermoney): Banking losses bigger than expected
“In mid-August one of the largest concerns for investors was uncertainty as to the impact the subprime issue would have on company profits. This uncertainty is quickly being diffused as companies in the US report Q3 figures. The news isn’t too good and we will probably have to wait a while longer for banks in Europe and Japan to report. The fact that the losses incurred by some banks are well above what was expected is impacting the market because it raises the possibility that their will be more high profile hedge fund blowups and weaker earnings generally.”
Source: Eoin Treacy, Fullermoney, October 24, 2007.
Wall Street Journal: China’s hand for Bear
“Wall Street’s Bear Sterns has been under fire for months as investors watched two internal hedge funds with exposure to risky, or subprime, mortgages implode. In its wake, the firm’s revenue and share price have fallen. On Labor Day weekend the Chairman and Chief Executive Officer went to China in hopes of sealing a partnership with Citic Securities, the large Beijing investment bank.
“Citic, one of China’s largest investment banks, and Bear, the New York securities firm known best for its bond operations, plan to fuse their Asian businesses outside of mainland China, creating a more broad-ranging footprint. How much access the joint venture will have to business within mainland China is yet unclear. As part of the newly minted Citic alliance, the 84-year-old Bear now has a crack at one of the fastest-growing underwriting and trading markets in the world, Asia.
“The tie-up is the latest sign of China’s growing ambitions in global financial markets, one outgrowth of the country’s fast-developing economy and efforts by Beijing to create world-class competitors in various industries.”
Source: Kate Kelly and James T. Areddy, The Wall Street Journal, October 23, 2007.
David Fuller (Fullermoney): Banks hold key to rest of markets
“The stock market rally overextensions have been apparent for several weeks and the rollover deterioration led by banks in the USA, Europe and Japan has also been noteworthy. I find the renewed deterioration by banks in these regions unnerving, not least because I maintain that what is good or bad for the banks is also good or bad for the rest of the market. In other words, we cannot divorce the financial industry from the rest of the economy. Therefore I would be surprised to see meaningful strength for stock markets prior to some upward dynamics by their banks, similar to what we saw in the second half of August and in September.
“That said, I would be very surprised if many of the broader stock market indices retested their August lows anytime soon.”
Source: David Fuller, Fullermoney, October 22, 2007.
Edward Tapamor (Resource Investor): $100 oil, here we come!
“Who would have thought it? Oil at $9 per barrel. You could never have imagined the price would fall so low. But just nine years ago in 1998, that is exactly where oil was: $9 per barrel. It is now trading at around 10 times that amount, and all bets are off as to where it will end up. We have had two quarters of draw-downs in stockpiles in the US and around the globe. What is worse, there are no signs of any builds in crude stocks for the next four to five months. That is what the market is betting on, at least.
“What is more prescient is the question of what news is there now that can bring the price down? What can move crude oil back to the levels where ordinary folk can feel comfortable and secure? The answer at the moment is nothing”.
Source: Edward Tapamor, Resource Investor, October 19, 2007.
Gavekal: Will Chinese growth to keep driving commodities prices higher?
“From an investor’s perspective, it is important to note that while the major producers are working with conservative estimates, market analysts tell us that commodity prices are, often pricing in near +11% GDP growth, from China for the next 3 – 4 years. As a result of the discrepancy between the suppliers benchmark growth rate and the investors expected growth rate, a significant Chinese-growth premium exists in commodity prices. As such, if Chinese growth goes from 11% to 9% – still well within the bullish China macro story – this premium could be eliminated, and commodity prices could collapse.
Source: GaveKal Checking the Boxes, GaveKal Research, October 25, 2007.
Dennis Gartman: Disclosure of US gold lending, swaps
“… while on the topic of gold, we shall nod in the direction of the folks at GATA who’ve argued for years … that the US government was manipulating the gold market via gold-lending operations. The government has denied that vehemently, even as GATA has trumpeted it relentlessly.
“Last week James Turk, one of GATA’s leading lights and a gentleman whose work ethic and tenacity we have come to admire over the years, wrote that: ‘… the US Treasury quietly made a subtle change to its weekly reports of the US International Reserve Position, which includes the US Gold Reserve. This change was first made May 14. It says the US Gold Reserve is 261.499 million ounces and importantly, that the gold is now reported ‘including gold deposits, and, if appropriate, gold swapped.’ This description provides clear evidence that the US Gold Reserve is in play. Gold has been removed from US Treasury vaults and placed on deposit, presumably in the couple of bullion banks the Treasury has selected to assist with its gold price-capping efforts. Gold placed on deposit gets loaned out by these bullion banks, and then sold into the spot market to try capping the gold price.’
[The gold price’s rise against this backdrop] “… is enormously bullish news of gold.”
Source: Dennis Gartman, The Gartman Letter, October 22, 2007.
BCA Research: Agriculture – structurally bullish
“Limited acreage growth and decreased water availability will constrain the supply-side response to higher agricultural commodity prices, both in the near and long term. The lack of land supply is particularly acute in geographies experiencing the fastest consumption growth. For example, arable land per capita in China and India is only 18% and 26% of US levels, respectively. Environmental degradation is further reducing available land supply; soil erosion occurs in two-thirds of China’s agricultural land (largely due to heavy fertilizer use), which undermines the long-term sustainability of agricultural production.
“Furthermore, water scarcity will be increasingly problematic. First, water availability is relatively scarce in China (water resources per capita are 25% of the world average). Second, water pollution is widespread, with 44% of Chinese rivers classified as polluted. Third, demand for water increases dramatically as meat consumption increases. The net result of the above two phenomena is dangerously low inventories of agricultural products.”
Source: BCA Research, October 22, 2007.
Mark Mobius (Templeton Asset Management): Outlook for emerging markets
Click here for a recent Financial Times video interview with Mark Mobius on the outlook for emerging markets.
Source: FT.com, October 2007.
GaveKal Research: Hong Kong – H-shares versus A-Shares
“Beijing’s push to liberalize its capital markets is providing another, potentially massive source of inflows. Most importantly, this obvious shift in policy direction has opened the floodgates for capital to flow from the extremely overheated Chinese market into the relatively more attractive Hong Kong market – thereby boosting the HK$ and HK asset prices further. In fact, this recognition led us to look for a relationship between the HK$-US$ and the relative performance of H-Shares and A-Shares, and low and behold, the correlation is impressive (see chart below). Today, the currency markets are now clearly indicating that H-shares will outperform A-shares over the near-term.”
Source: GaveKal Checking the Boxes, GaveKal Research, October 24, 2007.
BCA Research: Valuations of Chinese stocks resemble Japan of 1980s
Source: BCA Research, October 23, 2007.
MarketWatch: Paulson keeps up pressure on China’s yuan
“Treasury Secretary Henry Paulson reiterated that China should let its currency strengthen on Tuesday, following weekend meetings during which the world’s seven richest nations stepped up their pressure on Beijing over the yuan. That pressure, however, was met by a shrug from Chinese authorities, and the yuan was even allowed to sink a little in Monday trading. … Paulson also said China should speed up market reforms and open its economy to more international competition. He also singled out protectionism and slow reform in China as ‘the greatest risk to China’s long-term economic security.’
“Facing pressure from manufacturers and labor groups, the US and other countries have been pressuring China to let its currency rise in value. Paulson said that hastening the appreciation of the yuan ‘will help China deal with the imbalances that have grown in the economy and make monetary policy much more effective in responding to inflation.’ ‘Currency appreciation to date has not slowed the Chinese economy,’ Paulson said.”
Robert Schroeder, Market Watch, October 23, 2007.
Bloomberg: Jim Rogers Shifts Assets Out of Dollar to Buy Yuan
“Jim Rogers, chairman of Beeland Interests Inc., said he is shifting all his assets out of the dollar and buying Chinese yuan because the Federal Reserve has eroded the value of the US currency. ‘I’m in the process of — I hope in the next few months — getting all my assets out of US dollars,’ said Rogers, 65, who correctly predicted the commodities rally in 1999. ‘I’m that pessimistic about what’s happening in the US.’
Rogers … said he expects the Chinese currency to quadruple in the next decade and that he is holding on to commodities such as platinum, gold, silver, and palladium. ‘It’s the official policy of the central bank and the U.S. to debase the currency,’ said Rogers, a former partner of George Soros.
The Chinese currency, known as the renminbi, or yuan, is ‘the best currency to buy right now,’ Rogers said. ‘I don’t see how one can really lose on the renminbi in the next decade or so. It’s gotta go. It’s gotta triple. It’s gotta quadruple.’ Rogers also is buying Swiss francs and Japanese yen, which he said have been ‘pounded down’ because of the so-called carry trades.
The bull markets in bonds and stocks are ‘over,’ he said. ‘Bonds will be a terrible place to be for many years and will in fact be going down for many years.’ Rogers said he remains bullish on commodities because ‘that’s where the big fortunes are going to be made in the world in the next five, or 10 or 15 years. The current bull market is going to last until sometime between 2014 and 2022.’
Platinum, gold, silver and palladium will ‘be much, much higher during the course of the bull market,’ he said. He added, ‘I think I’m going to make more money in agriculture than I make in precious metals.’
Source: Marcel van de Hoef and Danielle Rossingh, Bloomberg, October 24, 2007.
Richard Duncan: Flaws in the dollar standard
“The Dollar Standard is the most appropriate name for the international monetary system that evolved following the collapse of the Bretton Woods System in the early 1970s. The principal flaw in The Dollar Standard is that it has no mechanism to prevent large and persistent trade imbalances between countries. Consequently, the deterioration in the United States’ current account deficit has gone unchecked, recently reaching nearly 7% of US GDP. The countries with a trade surplus with the United States have been blown into economic bubbles. Japan in the 1980s, the Asia Crisis countries in the 1990s, and China today are examples. Moreover, as the central banks of the United States’ trading partners have reinvested their dollar surpluses back into US dollar assets, the United States itself has also been blown into a bubble. In short, the US current account deficit has destabilized the global economy.”
Source: Richard Duncan, FinanceAsia, September 2007.
John Hussman: Treasuries are significantly overbought
“… Treasury securities performed very well, but are now significantly overbought. Barring immediate news of defaults and credit problems, my impression is that it may be difficult to keep yields at current lows without some correction, and that Treasuries remain vulnerable to sporadic inflation concerns. It’s still probable that we’ll see the year-over-year headline CPI inflation rate moving to about 4% by November (which is statistically “baked in the cake”). With the market apparently far more concerned with perception than reality when it comes to the Fed, any tendency toward higher inflation figures or substantial dollar weakness is likely to make investors fret that the Fed might not be able to “ease” as aggressively as it otherwise would. My view continues to be that all of this is psychological, but given how dependent overvalued markets can be on perpetually favorable psychology, the risk of any “disappointments” from the Fed could still be important.”
Souces: John Hussman, Hussman Funds, October 22, 2007.