10-year bonds may provide early warning

Thursday, September 3rd, 2009

The 10-year US treasury is indicating a substantial change in asset allocations in favour of bonds, as yields have returned to May ‘09 levels. This again has been a period where bonds and stocks have been rising together, and provides an early warning there may be trouble ahead for the economy and equities, as large investors are rotating  away from “risk” trades, in the midst of stronger equity market liquidity.

Chart: ZeroHedge

Tags: 10 Year Bonds, Ahead, Asset Allocations, Economy, Equity Market, Favour, Investors, Market Liquidity, Midst, Risk Trades, Stocks, Substantial Change, Us Treasury
Posted in Markets | No Comments »

Global Equity Market P/E Ratios

Friday, June 26th, 2009

Below is a chart showing global equity market valuations, as produced by Bespoke Investment Group. Canadian stocks are currently fetching a P/E of 13X, and given Canada’s relatively stronger economic fundamentals, from a fiscal and banking industry standpoint, and its significant commodity complex, are relatively attractive. It is notable that Canada’s P/E was around 9X back at the beginning of March, so the strong rally since has aided significant P/E multiple expansion off the lows.

Bespoke: As shown, Russia currently has the lowest P/E ratio at 6, followed by Italy (10) and France (11).  At 14, the US is more attractive based on its P/E ratio than most countries.  Taiwan has the highest P/E at 60, and the UK is surprisingly bad at 34.  It’s valuation is worse than China’s.  Germany also has a very high P/E ratio at 27.

Tags: 13x, Banking Industry, Canada, Canadian Stocks, China, Commodities, Commodity, Economic Fundamentals, Equity Market, Germany, Global Equity, Investment Group, Italy, Lows, Market Valuations, Rally, Ratios, Russia, Standpoint, Taiwan
Posted in Markets | 3 Comments »

World Markets Performance 2009 YTD

Monday, January 26th, 2009

Year-to-date equity market performance has been bleak, considering that out of 84 countries, 19 are up and the remainder are down. 17 countries are down more than -10%. China is the second best performing equity market so far, up 9.3%, and Brazil is the only other of the BRIC that is up, with a smaller gain of 2.49%.

Canada is the best performing G7 country with a smaller than the rest YTD loss of -3.50%.

Chart: Bespoke Investment Group

Tags: Brazil, BRIC, Canada, China, Equity Market, G7 Country, Investment Group, Market Performance, Remainder, World Markets, Year To Date, Ytd
Posted in Canadian Stocks, Markets | No Comments »

World Markets Bounce Off 52-Week Lows

Thursday, December 11th, 2008

The chart below highlights the recent performance bounces off 78 countries 52-week equity market lows. Its a good glimpse at which markets have recovered the most during the current relief rally, and those that have not done as well.

Hong Kong is up 46% off of its low just a few weeks ago.  BRIC countries have nice bounces off their bottoms.  Brazil is up the second most with a 34% increase, and India and China are both up 25%.  Russia has been the weakest BRIC country with a gain of 19.5%.  Of the developed countries, Japan’s bounce is the most at 24%, then the United States (22%), the UK, and Germany (18.9%).  Italy and Canada have had the weakest gains of 10.6% and 12.1% respectively in the G7 grouping.  Also, not all equity markets have had recovery rallies in recent weeks.  11 of them are trading less than a percent from their 52-week lows.

Chart: Bespoke Investment Group

Tags: 52 Week Lows, Bottoms, Bounces, Br, Brazil, BRIC, Bric Countries, Canada, Chart, China, Current, Developed Countries, Eco, Emerging Markets, Equity Market, Germany, Glimpse, Hong Kong, Img, India, Investment, Investment Group, Italy, Japan, Markets, Rallies, Rally, Russia, Trading, UK, United States, World Markets
Posted in Markets | No Comments »

Credit Crisis Watch (December 8, 2008)

Monday, December 8th, 2008

In order to gauge the progress being made to unclog credit markets and restore confidence in the world’s financial system, I monitor a range of financial spreads and other measures. By perusing these, as summarised in this “Credit Crisis Watch” review, one can ascertain to what extent the various central bank liquidity facilities and capital injections are having the desired effect.

First up is the LIBOR rate. This is the interest rate that banks charge each other for one-month, three-month, six-month and one-year loans. LIBOR is an acronym for “London InterBank Offered Rate” and is the rate charged by London banks, and which is then published and used as the benchmark for banks’ rates around the world.

After having peaked on October 10 at 4.82%, the three-month dollar LIBOR rate declined sharply to 2.13% on November 12, but the healing process has since been moving sideways with the current rate at 2.19%. LIBOR is therefore trading at 119 basis points above the Fed’s target rate of 1.0%, compared with 43 basis points at the start of the year.

Source: StockCharts.com

Importantly, the US three-month Treasury Bills are trading at a “non-existent” 0.015%, indicating that liquidity is still being hoarded by risk-averse investors.

US three-month Treasury Bill yield

Source: The Wall Street Journal

The TED spread (i.e. three-month dollar LIBOR less three-month Treasury Bills) is a measure of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. On the other hand, when the risk of bank defaults is considered to be decreasing, the TED spread narrows.

Since the TED spread’s peak of 4.65% on October 10 the measure has eased to 1.75%, but has since widened to 2.18%.

Source: Fullermoney

The difference between the LIBOR rate and the overnight index swap (OIS) rate is another measure of credit market stress.

When the LIBOR-OIS spread is increasing, it indicates that banks believe the other banks they are lending to have a higher risk of defaulting on the loans so they are charging a higher interest rate to offset this risk. The opposite applies to a narrowing LIBOR-OIS spread.

The movement in the LIBOR-OIS spread over the past few weeks is similar to the TED spread and shows that credit markets are still not functioning properly.

Source: Fullermoney

Fed actions to buy up to $500 billion of mortgage securities backed by Fannie Mae, Freddie Mac and Federal Home Loan Banks and purchase up to $100 billion of debt issued by these agencies have resulted in a sharp drop in mortgage rates. The 30-year fixed-rate mortgage averaged 5.53% for the week ended December 5, down from 5.97% the previous week following a high of 6.36% for the week ended October 31. This is certainly a move in the right direction.

As far as commercial paper is concerned, the A2P2 spread measures the difference between A2/P2 (low quality) and AA (high quality) 30-day non-financial commercial paper. The spread has kicked up from 4.27% a week ago to its record high of 4.83%, indicating a crisis environment.

Source: Federal Reserve Release - Commercial Paper

Similarly, junk bond yields continue to rise in parabolic fashion, scaling record highs as shown by the Merrill Lynch US High Yield Index. The spread between high-yield debt and comparable US Treasuries was 2,074 basis points by the close of business on Friday - an increase of more than 750% since bottoming in June 2007. With the US 10-year Treasury Note yield at 2.71%, high-yield borrowers have to pay 23.45% per year to borrow money for a ten-year period. At these rates it will be practically impossible for those companies with less-than-perfect credit status to conduct business profitably.

Source: Merrill Lynch Global Index System

Another indicator worth keeping an eye on is the Barron’s Confidence Index. This Index is calculated by dividing the average yield on high-grade bonds by the average yield on intermediate-grade bonds. The discrepancy between the yields is indicative of investor confidence. A declining ratio indicates that investors are demanding a higher premium in yield for increased risk. A slight improvement has taken place over the past week, but hardly of the magnitude to indicate restored confidence in the economy.

Source: I-Net Bridge

According to Markit, the cost of buying credit insurance for US, European, Japanese and other Asian companies worsened considerably over the past week as shown by the wider spreads (basis points) for the following five-year credit indices (in some instances rising to record levels):

• CDX (North American, investment-grade) Index: down from 233 to 274
• CDX (North America, high-yield) Index: down from 1,376 to 1,461

• Markit iTraxx Europe Index: down from 163 to 216
• Markit iTraxx Europe Crossover Index: down from 869 to 1,094

• Markit iTraxx Japan Index: down from 320 to 375
• Markit iTraxx Asia ex Japan IG Index: down from 360 to 435
• Markit iTraxx Asia ex Japan HY Index: down from 1,218 to 1,300

The graphs of the CDX indices are shown below, with the red line indicating the spreads easing over the past few days.

CDX (North American, investment-grade) Index

Source: Markit

CDX (North America, high-yield) Index

Source: Markit

Quoting Moody’s Investors Services, the Financial Times reported that since the Lehman bankruptcy yields on BAA-rated bonds (investment grade) have risen by a third while yields on equivalent US Treasury bonds have dropped by a quarter. “That means the extra yield investors need before they will lend to investment-grade companies has gone from 2.7 to 5.9 percentage points in three months. This is a crisis,” said the article.

Credit markets are therefore bracing for huge defaults. According to Deutsche Bank, “current spreads imply a 50% default rate for high-yield credits and an ‘inconceivable’ default rate for investment-grade companies.” They believe government intervention to prevent defaults on such a scale would be inevitable.

Next, some credit default swap (CDS) statistics, courtesy of Bespoke. Since a month ago the cost of insuring against government bankruptcy through CDSs has risen for all but two countries (Lebanon and Argentina) in Bespoke’s list of 38 countries. The table below shows the current (December 4) CDS prices, together with month-ago and start-of-year prices. Argentina, Venezuela, and Iceland have the highest default risk.

Interestingly, Germany, Japan, and France all have lower default risk than the US at the moment. It now costs $60 per year to insure $10,000 against US default for the next five years. “While this may not seem high, it was at $8 earlier in the year, and $36 one month ago,” said Bespoke.

As shown in the table below, Ireland, Austria, Greece, and the UK have seen default risk rise the most over the last month. Notably, the US has risen by 68%.

Still on the issue of CDSs, Bespoke points out that even as equity markets and the financial group have begun to show some signs of stability, default risk remains elevated. This is seen from the graph of their Bank and Broker CDS Index that measures default risk for 13 global financial firms. “While default risk is not nearly as high as it was prior to the initial TARP plan, its inability to ease is still cause for concern,” said Bespoke.

In summary, the CDX and iTraxx credit indices, US Treasury Bills and high-yield spreads are still at distressed levels. Some improvement has been seen as a result of central banks’ actions, notably the tightening of the TED and LIBOR-OIS spreads, and the decline in mortgage rates.

As long as distrust in the banking sector remains high and banks do not lend to each other, the credit situation will remain tight. Credit spreads need to narrow further to indicate that liquidity is starting to move freely again. Only then will confidence in the financial system start improving and the thawing of credit markets get under way.

Author: Prieur du Plessis, Plexus Asset Management, Investment Postcards

Tags: Acronym, Asia, Bank Liquidity, Banks, Basis Point, Basis Points, Bond Yields, Bonds, Borrow Money, Br, Capital Injections, CDS, Central Banks, Chart, Commercial Banks, Credit, Credit Crisis, Credit Default Swap, Credit Market, Credit Markets, Credit Risk, Credit Situation, Credit Spreads, Current, Current Rate, Desired Effect, Diffe, Dollar, Dow, Eco, Economy, Equity Market, Euro, Fannie Mae, Fed, Federal Home Loan, Federal Home Loan Banks, Federal Reserve, Financial Spreads, Financial Times, France, Freddie Mac, FT.com, Germany, Greece, Healing Process, high yield, Home Loan Banks, Img, Information, Investment, Investment Postcards, Investors, Japan, Libor Rate, liquidity, London Banks, London Interbank Offered Rate, Markets, Measures, Merrill Lynch, Money, Mortgage, Overnight Index Swap, Plexus Asset Management, Prieur, risk, Signs, spreads, T Bills, Target, Target Rate, Tarp, Trading, Treasuries, Treasury Bill, Treasury Bills, Treasury Bonds, Treasury Note, UK, Us Treasury, Venezuela, Wall Street, Wall Street Journal
Posted in Bonds, Credit Markets, Economy, Markets | No Comments »

Baltic Dry Index: A Valuable Leading Indicator?

Friday, December 5th, 2008

The Baltic Dry Index is a very important indicator of the health of trade globally, as it measures shipping activity in dry cargo.

Take a look at the chart below: According to the BDI, one of the purest economic indicators, the activity of shipping dry bulk cargo, mainly consisting of commodities such as coal, steel, iron ore, and cement, has almost completely ground to a halt, as indicated by the crash in the index’s value.

The BDI offers a real time glimpse at global raw material and infrastructure demand. Unlike stock and commodities markets, the Baltic Dry Index is totally devoid of speculative players. The trading is limited only to the member companies, and the only relevant parties securing contracts are those who have actual cargo to move and those who have the ships to move it. ^[1]

Another interesting feature of the BDI, is its high correlation to equity markets. Take a look at BDI vs. S&P500 and FXI (China 25 Index iShare), Crude Oil and Copper:

Baltic Dry Index vs. S&P 500

Baltic Dry Index vs. FXI (FTSE Xinhua 25 Index iShare)

Baltic Dry Index vs. Crude Oil

Baltic Dry Index vs. Copper

We’ll keep an eye on credit markets, and the Baltic Dry Index as indicators of the vitality (or lack thereof) of the economy and markets and keep you posted.

As goes the BDI (a leading indicator), so goes the economy, and perhaps equity markets (and commodities, we might add).

At the time of the publishing of this article, the BDI stands at 663 pts.

Tags: Array, Baltic Dry Index, Bdi, Blog, Br, Bulk Cargo, Cargoes, Cement, Chart, China, Coal, Commodities, Commodities Prices, Copper, Correlation, Crash, Credit, Credit Market, Credit Markets, Crude Oil, Debacle, Dow, Dry Cargo, Eco, Economic Indicators, Economy, Equity Market, Failure, FTSE, Ftse Index, Ftse Xinhua, Fxi China, Glimpse, Grains, Health, Img, Infrastructure, Investment, Iron Ore, Ishare, Issuance, Leading Indicator, Lehman Brothers, Loc, Markets, Measures, Member Companies, oil, P500, Php, Precipitate, Raw Material, Relevant Parties, S&P 500, S&P500, Shipping Activity, Time Glimpse, Trading, Value, Vitality
Posted in Commodities, Credit Markets, Economy, Markets, Oil and Gas | No Comments »

Bill Gross, Investment Outlook, December 2008

Wednesday, December 3rd, 2008

In his latest Investment Outlook, Bill Gross, head honcho at PIMCO, discusses the advent of transitioning from the levering world of pre-2008 into the delevering world we now find ourselves in. He points out that in the “new” world we should no longer apply the measures of the past for concluding that stocks are cheap, and that it is a transgenerational idea we need to retool for.

Gross points out the “Q” ratio and Robert Shiller’s 10 year average P/E ratio (above) as evidence that stocks are arguably cheap, but goes on to discredit the reliability of these indicators, saying:

“Professor Shiller may be on to something, although even his 10-year approach may not be enough to adjust for our future economy and its functioning within the context of a delevering as opposed to a levering financial system. Recent Investment Outlooks and indeed, discussions in PIMCO’s Investment Committee and Secular Forums for the past several years have pointed to the necessity to view current changes as not only non-cyclical, but non-secular. They are, in fact, likely to be transgenerational. We will not go back to what we have known and gotten used to. It’s like comparing Newton and Einstein: both were right but their rules governed entirely different domains. We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people’s money. Welcome to a new universe stock market investors! In this rather “sheepish” as opposed to “brave” new world, here are some considerations that may affect Q ratios, P/E’s, and ultimately stock prices for years to come:

1. Corporate profits have been positively affected for at least the past several decades by several trends that appear to be reversing. Leverage and gearing ratios - the ability of companies to make money by making paper - are coming down, not going up. In addition, the availability of cheap financing - absent government’s checkbook - will likely not return. Narrow yield spreads and low real corporate interest rates are gone. Last, but not least, the historical declines of corporate tax rates, shown graphically in Chart 3, will not likely continue downward in a Democratically-dominated Washington.
2. Globalization’s salutary growth rate of recent years may now be stunted. While public pronouncements from almost all major economies affirm the necessity for increased trade and policy coordination, and avoiding the destructive tendencies of one-off currency devaluations as a local remedy for global problems, investors should not bank on the free trade mentality of recent years to support historic growth rates. Already we are seeing separate ad hoc policy responses with very little cooperation. Not only does the EU’s approach differ from that of the U.S., but France is in many ways an odd man out within its own community. Asia is legitimately suspicious of any U.S. endorsed approach given the failure of America’s capitalistic model.
3. Animal spirits, and with them the entrepreneurial dynamism of risk-taking has likely experienced a body blow. Not only have dancers on the financed-based dance floor been shown the exit à la Chuck Prince, but those that remain have been publicly chastened and handcuffed. Golden parachutes, options, executive compensation and bonuses themselves are now at risk. Care to climb to the throne of this new world? Well, yes, egos will always dominate, but the rules will be changed and hormone levels lowered.
4. The benevolent fist of government is imperative and inevitable, but it will come at a cost. The champion of free enterprise, Ronald Reagan, knew that growth of the private sector was in no small way dependent on deregulation and the lowering of tax rates. Now that those trends have necessarily come to an end, no rational investors should expect innovation and productivity to be unaffected. Profit and earnings per share growth will suffer.

My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to - that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner.”

In a recent article we noted that the trailing P/E ratio of the S&P500 had ticked up in the year-to-date to November 10, 2008, while the overwhelming majority of global equity markets had experienced substantial P/E compression. This suggested that the E (for earnings) had declined as much as P (for price)in the S&P500. Is the S&P500 due for P/E compression?

You may read the Bill Gross’ Investment Outlook newsletter in its entirety here.

Tags: Advent, Asia, Bill Gross, Blog, Br, capitalism, Cement, Chart, Chuck Prince, compression, Corporate Profits, Credit, Currency, Current, Deflation, Diffe, Dow, Earnings, Eco, Economy, Einstein, Equity Market, Failure, Fed, France, Gearing Ratios, globalization, Gold, Gross Head, Gross Investment, Head Honcho, Img, interest rates, Investment, Investment Committee, Investment Outlook, Investors, Invisible Hand, Leverage, Loc, Markets, Measures, Money, New Universe, Outlook, Outlooks, P/E, P500, People, PIMCO, risk, Robert Shiller, S&P500, spreads, Stock Market, Stock Market Investors, Stock Prices, Stocks, Transitioning, Trumps, Universe, Valuations, Value, Valuing Stocks
Posted in Credit Markets, Economy, Gold, Markets, Outlook | 2 Comments »

10-Yr+ US Treasury and Canada Yields Falling

Monday, December 1st, 2008

During the December 1st liquidation of stocks, the yield on 10-Yr. US treasury securities fell to 2.81%, a level not seen since 1954. Incidentally, during the 1935-1955 period, the yield on these was at levels far below current levels, this being the period following the collapse of the US financial market post circa 1929.

With the bond market rallying in the longer durations, its hard to NOT see how this plays right into the hands of the US government’s needs for long-term funds to pay for a trillion-dollar war and a trillion-dollar plus bailout, not to mention just staying in business.

Bloomberg says: Yields on two-, 10- and 30-year debt dropped to levels not seen since the U.S. began regular sales of the securities after Federal Reserve Chairman Ben S. Bernanke said the central bank may purchase Treasuries and target long-term interest rates to combat the deepening recession.

Which once again begs the question:

What incentive does the US Government have for reviving the equity market, except to levels which keep some hope alive? Not much, right now.

With investors being crowded out of equity markets by continuing volatility and losses surmounting from deleveraging, it should eventually be a snap for Washington to amortize very sizable short term obligations by selling bonds to fleeing investors. Bernanke is merely pointing out the obvious in a roundabout way.

Debt is the new equity. Why would you bet against the Fed? This is the direction they have been moving us in, deliberately.

Canada Long Bond Yields Falling

By the way, the 30-year Canada rates fell from 3.97% last week, to 3.76% today, in the face of the 9% drop in the TSX. Until 5 months ago, the Canadian economy was bolstered nicely by rich commodities prices. Now that commodities prices have fallen sharply and fairly quickly, Canadian investors haven’t yet adjusted to the reality that Canada is in recession too, and given that, it is likely the long-term Canada yields will fall. Our three key industries are now dealing with a slump; autos, financials, and commodities.

Which is the likely scenario over the next one to two years: Long-term Canada Yields go up, sideways, or down, given that Canada is entering a full-blown recession?

Bloomberg says: The yield on the two-year bond declined 12 basis points, or 0.12 percentage point, to 1.59 percent at 4 p.m. in Toronto, the lowest since Bloomberg records began in 1989. The price of the 2.75 percent security due in December 2010 rose 23 cents to C$102.29.

The 10-year note’s yield fell 19 basis points to 3.13 percent, also the lowest since at least 1989. The price of the 4.25 percent security maturing in June 2018 climbed C$1.66 to C$109.18.

“Long-term rates are playing catch-up in terms of the decline in yields we have seen in short-term bonds,” said Mark Chandler, RBC Dominion Securities Inc. “There is limited downside in short-term yields,” he said.

“The relatively greater drop in yields on long-term bonds compared with short-term bonds is a theme that could continue into the first half of 2009,” Mr. Chandler said. “This is known as a yield curve flattener,” as the spread between the short-term and long-term rates narrows.

Currently, Canada’s yield curve is steep, defined by short term rates near zero percent, and 30 year rates, which closed today (12/01) at 3.761%, down 21 bps from last Thursday (11/27) morning.

As Hugh Hendry recently put it:

“I withdrew my hard-earned money from a bank this summer. But it may surprise you to learn that I bought government bonds of long duration. Surely I should have bought gold? Except that I believe the way to make money is to seek opportunities through paradox.

And therein lies our brinkmanship: everyone has skipped our story and read the conclusion. They fear financial anarchy. Gold coins are sold out. Everyone is in. And yet the price of gold has fallen this year. So, for now, I would stick with the bonds. The 18-year British gilt yields 4.8pc but, with the Bank of England likely to follow the Fed and slash rates to 1pc, I believe we could see gilt yields below 3pc.

And I promise you that if bond yields broke 3pc there would be a stampede to buy. At this stage gold might trade close to $500, and those who missed its rally from 2002 would have the solace of schadenfreude when in reality they should be buying the stuff and selling their bonds. What delicious irony: deflationists and inflationists could both claim to be right. But how many will have profited?”

Tags: Bailout, Basis Point, Basis Points, Bernanke, Blog, Bloomberg, Bond Market, Bond Yields, Bonds, Bps, Br, Canada, Canada Rates, Canadian Economy, Canadian Investors, Collapse, Commodities, Commodities Prices, Current, Deflation, Dollar, Dollar War, Dow, Eco, Economy, Equity Market, Fed, Federal Reserve, Federal Reserve Chairman, Financials, Gold, Government Bonds, Hugh Hendry, Img, inflation, interest rates, Investors, Key Industries, Liquidation, Loc, Loom, Markets, Money, oil, Rally, Recession, REW, Rose, Roundabout Way, Snap, Stocks, Stuff, Target, Term Bond, Term Funds, Term Interest, Term Obligations, Treasuries, Treasury Securities, Trillion, Tsx, Us Government, Us Treasury, Volatility, Yield Curve
Posted in Bonds, Canadian Stocks, Commodities, Economy, Gold, Markets, Oil and Gas | No Comments »

‘Encouraged by a wicked wizard, Greenspan, Bernanke toils at his printing press’

Friday, November 28th, 2008

The Guardian has published below, an insight-full essay by Hugh Hendry, CIO, Eclectica Asset Management. Hendry’s brash and eloquent commentary has earned him a reputation which he best personally describes as heresy, as many in the City of London have tried at times to dismiss his bold and controversial views.

Again, Hendry closes in on his decision to be long the long government bonds, as he contends that long term rates will come down as central banks globally, have little choice but to follow the Fed to lower interest rates over the next year or two.

As markets liquidated in the deleveraging fervour that has proliferated this year, investors have piled into short term treasury bills and money market instruments. As sentiment for equity markets and commodities continues to wane, its starting to appear more likely that short term bond money will go in search of yield further along the yield curve, and as it does the rather steep yield curves should flatten.

Here’s another thought. What incentive does the US government have for reviving the stock market? After all, where else are they going to get the money to pay for a trillion-dollar war and a trillion-dollar bailout, but the bond market? It would serve government if an entire segment of investors fled into the longer (duration) end of bond the market for capital safety so as to indemnify those at the printing presses.

The Wizard of Oz must be one of the creepiest stories ever told.

“The past 30 years of economic history may have produced a daunting sequel to the original Wizard of Oz, written by Frank Baum.

By Hugh Hendry
Last Updated: 10:59AM GMT 27 Nov 2008

Follow the yellow brick road to get a picture of where we are

People blame this crisis on cheap money and greedy bankers. They certainly cannot be exempted. But I take a more fatalist point of view. There has to be a reason for humans to die off in their 70s and 80s. I believe it is so that the memory of a generation’s mistakes is erased, allowing future ages to repeat the folly of greed and fear.

Because of this, I spend a lot of time reflecting on social mood and behaviour. Popular fiction is a particular fascination; I believe it provides a mind map of the social conscience. The Wizard of Oz is a personal favourite. I would contend that bullish markets produce feel-good films, like Disney animation; that bear markets produce depictions of horror and foreboding (think Hammer House of Horror in the 1970s and SAW, its modern equivalent); and that social mood is linked to stock market patterns.

The original Frank Baum story was written as a political allegory of America’s entry on to the gold standard in 1879. The strictures of sound money coincided with a vibrant post Civil War economy. The result was deflation: prices fell by 1.7pc pa between 1875 and 1896. The farmer, as depicted by the scarecrow, was held captive by falling agricultural prices and mortgages owed to the big banks, the wicked witch of the east. The spell of tight monetary policy cast a pall over the poor tin woodsman: every time he swung his axe, he chopped off part of his body. It was a depiction of the economy’s shuttered and rusting factories.

The easy-money crowd, Bernanke and Greenspan’s great grandfathers perhaps, argued the responsibility for the economy’s woes lay with an insufficient monetary response. The gold market had a scarcity that choked the US economy into serfdom.

Instead, the populists’ manifesto called for the readmission of more plentiful silver coinage into the system – a point captured by Dorothy’s silver slippers (Hollywood changed them to ruby) as she skipped along the yellow brick road (the gold standard). Print more money and remove us from penury. Consecutive presidential elections were contested on such a return to bimetallism in 1896 and 1900. Surprisingly, the easy-money crowd, proved unsuccessful; they were defeated by powerful bankers such as JP Morgan. However, the story ends with the good witch of the south (the populace) prophesying that Dorothy’s silver slippers (easy-money policy) are so powerful they can fulfil her every wish. This utopia was made possible just 13 years later with the formation of the Federal Reserve. The tin man and the scarecrow would have a more forgiving lender of last resort after all and 71 years later the wizard, called Nixon, went one step further and abolished the need for gold and silver ounces (Oz) when the US reneged on its Bretton Woods commitment to sound money.

Of course, today we could be watching a comparable parable unfold. The past 30 years of economic history may have produced a daunting sequel. I would suggest tomorrow’s fiction will prove much darker, perhaps in the image of Goethe’s Faust.

The story would feature an apprentice printer called Bernanke. Encouraged by a wicked wizard, Greenspan, he toils at his printing press night and day producing reams of paper money. At first his monetary accommodation seems to bring unbridled prosperity. Boom follows boom, as the business cycle is seemingly abolished, house prices grow to the sky and his political stock rises. In time, the scarecrow is bought-off by crop subsidy; the tin man vacations in Vegas, having refinanced his mortgage for the 13th time. And the sorcerer’s apprentice is promoted to top wizard.

However, Greenspan, now in retirement, finally reveals his scheme has brought only “bogus riches”. The printing presses have created a “zero-sum game” where dollars lose their purchasing power against God’s brew of precious metals. The populace begins to save. Spending is reined in. Even the corporate sector suffers. With consumers no longer spending, there are no profits. Shares slump and the fiat kingdom collapses in anarchy.

And that is pretty much where we are today.

I withdrew my hard-earned money from a bank this summer. But it may surprise you to learn that I bought government bonds of long duration. Surely I should have bought gold? Except that I believe the way to make money is to seek opportunities through paradox.

And therein lies our brinkmanship: everyone has skipped our story and read the conclusion. They fear financial anarchy. Gold coins are sold out. Everyone is in. And yet the price of gold has fallen this year. So, for now, I would stick with the bonds. The 18-year British gilt yields 4.8pc but, with the Bank of England likely to follow the Fed and slash rates to 1pc, I believe we could see gilt yields below 3pc. And I promise you that if bond yields broke 3pc there would be a stampede to buy.

At this stage gold might trade close to $500, and those who missed its rally from 2002 would have the solace of schadenfreude when in reality they should be buying the stuff and selling their bonds. What delicious irony: deflationists and inflationists could both claim to be right. But how many will have profited?

Hugh Hendry is the co-founder of Eclectica Asset Management.”

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China Oversold?

Wednesday, April 2nd, 2008

Apr. 2, 2008 - Courtesy: Bespoke Investment Group - The Baltic Dry Index measures changes in the cost to transport raw materials such as metals, grains and fossil fuels by sea. Many look to the Baltic Dry Index as a leading indicator, and in recent years, its move has been fairly correlated with China’s economy and the Shanghai Composite.

As shown in the chart below, China’s equity market and the Baltic Dry Index had huge rallies from the end of 2005 to the end of 2007. They also had huge declines after they peaked late last year. Since late January, however, the Baltic Dry Index has been climbing while China’s Shanghai Composite has been falling. This divergence suggests that China’s equity markets might be getting a little overdone on the downside at least in the short term.

Tags: Baltic Dry Index, Chart, China, China Economy, China Market, China S Economy, Declines, Divergence, Downside, Economy, Equity Market, Fossil Fuels, Grain, Grains, Index Measures, Investment, Investment Group, Leading Indicator, Markets, Metals, Rallies, Raw Materials, Shanghai Composite
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