After rallying strongly in the first part of the year, stock markets in most countries seem to be taking a breather. Investors, many of whom missed the earlier rally and are still shell shocked from the
declines of 2008, must ask themselves “where do we go from here?” It doesn’t help that their inboxes and the cable channels are filled with contradictory recommendations from so-called experts.
Conflicting forecasts abound for such things as inflation vs. deflation, bear market rally vs. rally of a lifetime, China the investors’ dream vs. China the world’s greatest scam, or buy/sell gold and the dollar.
It also doesn’t help that nominal yields on short term low risk instruments in most major countries are running below one percent. At least in the late 1970s you could comfortably sit back, collect a nice return on your money market fund and watch the world fall apart. The major central banks, with their policies of extraordinary monetary base growth and quantitative easing have adopted a policy that leaves savers out in the cold. Financial repression is what the textbooks call it. The “fat spread” policy is what some in the financial press have called it. The current level of interest rates and the steep yield curve are designed for the banks, not for the world’s savers. Even Citibank and the Royal Bank of Scotland can borrow at .5% and lend at 5% and make a profit.
Finally decoupling – that much maligned idea that Asian stock markets could have a low correlation with the US market – after failing investors miserably in 2008 has made a comeback in 2009. Thus far, year-to-date the US Dow Jones Index is up 11.1%, the FTSEurofirst 300 is up 20.9%, Shanghai A Shares are up 56%, the Hong Kong Hang Seng is up 50.1%, the Singapore Straits Times Index is up 52.5% and the Bombay Stock Exchange is up 73.3%. Decoupling in 2009 is alive and well.
So Far in 2009 It Didn’t Pay to Be an Economist
From the viewpoint of investing, focusing on the economy alone in 2009 so far has turned out to be a mistake. Yes, US housing prices collapsed, the US consumer is retrenching, tax data as analyzed by such independent sources such as TrimTabs show a very bleak picture. Yes, in Asia the export model collapsed as forecast and millions of workers on the China coast became unemployed. But us pessimists who got the economy right overlooked the compelling valuations that existed in 1Q2009 and the massive governmental response to what was rapidly becoming the next Great Depression. The stimulus package provided a glimmer of hope to stock markets that had priced in a Depression. In China, the government commanded its banks to lend and the money sloshed into the stock and property markets in China and Hong Kong.
Whether long term these stimulus packages will bring worse problems than the ones they were supposed to solve remains an open question. But economics isn’t everything. The US stock market experienced a major rally from 1933-1937 even though unemployment never got below 14% from 1931-1940. In its fifteen years of more or less continuous recession from 1990-2004, Japan experienced a number of significant rallies in its stock market. Of course after each rally the market would retreat to new lows. That’s what the bears are predicting for the US market today.
Taking a Look at China
China may be one of the most exciting investment themes for the next fifty years but it is not always a buy. I wrote in the last Dismal Optimist, just after the Shanghai market had corrected, that the outlook for the Chinese market (including Hong Kong) was probably flat between now and the end of the year. I’m sticking to that view. Valuations are not as compelling as the beginning of 2009 and the mainland authorities have to hit the brakes to some degree on bank lending. The IPO pipelines in New York, Hong Kong and Shanghai are suddenly filled with Chinese firms eager to take advantage of the new valuations. But although some deals have gotten done, they have overall been disappointments. This is not a good sign.
Longer term the China story is still an exciting one. China may lack transparency, suffer from corruption, have major state controlled banks that are less sound than they seem and have a preponderance of state owned firms that are fundamentally unprofitable. But infrastructure wise China is moving at light speed. And China has a population of 1.3 billion homogeneous, hard working people who sincerely want to be rich. Its government knows that and shares that goal. Clearly longer term you want to invest in the “new China” – domestic oriented, genuine private sector companies.
Investing in Hong Kong stocks may be one way to do this. A number of Chinese stocks are traded in Hong Kong and most Hong Kong companies are now heavily involved in China.
Parenthetically, I am convinced Hong Kong will become China’s number one financial center once the renminbi is freed up. The just announced relocation of the top brass at HSBC from London to back to their roots in Hong Kong is perhaps one indicator of Hong Kong’s long run promise. A key Taipan is returning… Actually there is no one “Chinese” stock market. There is Shanghai, Shenzhen, Hong Kong, New York, Taipei and Singapore. This fragmentation is harmful to China but will persist until the renminbi becomes fully convertible.
Taking a Look at the United States
I am less optimistic about the US stock market overall near term. I cannot help but be influenced by the current underwhelming economic numbers. The consumer is still overleveraged, federal and state tax receipts are lagging, the housing market if it has bottomed is being financed by the FHA and a now nationalized Fannie and Freddie. A wave of new bank failures, commercial real estate loan defaults and new problems from resetting Opt –A residential mortgages are up ahead. A mild inventory restocking GDP boost followed by a relapse is a possibility for the US economy—the “w” pattern. The US is essentially in a multi-year recovery from consumer debt deflation. Moreover there is a major political uncertainty. From 1980-2008 the US was governed by a series of Presidents and Congresses who were pro-economic growth, relatively lower tax oriented and non-redistributionist. That has changed. The Obama Administration and the Democratic controlled Congress favor higher taxes, increased government regulation, a redistributionist health care policy and a costly energy program oriented to perceived environmental, rather than economic goals. Depending on one’s political views, this may or not be good for the country. But I can’t see how it’s good for the stock market. A comparison with the Roosevelt Administration during the 1930s remains appropriate. As recorded in Amity Shaes controversial The Forgotten Man, The Roosevelt Administration repeatedly raised taxes, maintained an anti-business stance and, in the opinion of many, prolonged the Depression.
Some Investment Ideas for Right Now
Cash The real return on cash is higher than the nominal. The world is in deflation. The CPI as of August was down YOY -1.4% for the US and -1.2% for China. So investors shouldn’t suffer from money illusion. In real terms cash has a positive return albeit modest. And given the huge diversity of opinion prevailing in the analytical community regarding the near term direction of the markets and currencies, having too much cash right now is not a bad thing. Investors who missed the worldwide rallies earlier this year shouldn’t compound their error by chasing the markets now. The lows in the markets earlier this year perhaps were a once in a lifetime opportunity. But investors can be patient. In the investing world, once in a lifetime opportunities come regularly about every one to two years.
Dividends plus Growth In the US investors are taking on risk and reaching for yield in such things as high yield bonds, bank stock preferreds, pipeline LLCs, high dividend stocks and mortgage REITs. Of course each one of these categories is a little different. But they are all more than a pure long term interest rate bet. My view is that deflation will be with us for the next one to three years, that the Fed will want a steep yield curve to maintain a fat spread for the banks and that Lehman Brothers type crisis is not likely to repeat. So buying something with a big yield, a growth possibility and/or a possibility of a quality upgrade is not a bad idea. Three caveats: One, if and when the consensus forecast turns from deflation to inflation, today’s high yields may not seem so high. So this is not a buy and hold forever strategy. Two, the Bush favorable taxation on dividends automatically expires at the end of 2010. Don’t hold your breath for an extension. Three, the US utility sector while it may pay attractive yields could experience a welter of environmentally derived regulatory problems.
Gold In my opinion gold should be purchased as a type of insurance against a general flight from currencies and the current international monetary system. Central banks have printed high powered money with wild abandon, notably the Federal Reserve. Longer term there is a definite inflation risk. Moreover there is an overall disrespect for the integrity of paper currencies. The recent bout of monetary excess could never happen under the traditional gold standard. One might ask why anyone would trust a central bank that figuratively throws money out of helicopters. Moreover, China has continuously complained about the dollar’s role as the principal global reserve currency. Special Depository Receipts issued by the IMF are in my opinion never going to replace real currencies. There are only two things the Chinese can do. One is free up the renminbi so to allow it to compete with the dollar as a reserve currency. The other is to buy gold. I believe they will do both. It has been said that investors should buy gold and hope that it will go down. Because if gold goes up, it will reflect a deteriorating global financial system. And that would be a terrible event. But if it goes down, the rest of investors’ portfolios will go up.
Some Addional Longer Term Ideas
Investors should look globally for ideas. China is one place to look. Here are some additional ideas that can benefit from ongoing long term secular trends. All these markets are up. Buying on pullbacks would be smart but, if the truth be told, neither I—nor anyone else – has any idea whether or when there will be a pullback.
India India is ignored by most global investors partly because of difficulties in buying stocks directly in India and the paucity of Indian stocks available for trading in New York and other foreign markets. But India is likely to show a GDP growth rate right behind China and it will be one not as propped up by a stimulus program as was China’s. India has major world corporations and not just in software. Most economists have concluded that India deploys its capital much more efficiently than China. If you want you can read (uncensored) Indian newspapers on line in English and get some idea of what is really going on in the country. Most importantly, a major political transformation has occurred in India. In recent elections, the ruling Congress Party scored a major victory. The Congress hardly could be described as “market wallah” in its economic orientation but the Congress government is headed by Oxford economics PhD Manmohan Singh who played a major role in the Indian economic reforms of 1991. The opposition BJP party – which is the only other national Indian party – seems to be imploding. The Indian market on a P/E basis is twice what it was at the beginning of the year and above its own historical average. But if a secular change is really underway in the country the historical PE will be irrelevant.
Taiwan Recent elections and corruption convictions of Taiwan’s pro-independence former president have seen Taiwan swing back to a more conciliatory approach to China. Taiwan may be a great backdoor way to invest in China. There are great companies in Taiwan that may have been held back by the country’s restrictive policies vis a vis China in the past. Ignore the occasional political bumps here. The integration of Taiwan’s economy with that of China is unstoppable and a positive for the Taiwanese stock market. Another multiyear secular trend.
Australia – A core population with developed country work habits and no major racial divisions, a British-derived legal tradition, a treasure house of raw materials, a Pacific location, English speaking and an influx of new hard working immigrants from Asia – what’s there not to like about Australia? Well there is one risk. That would be a collapse in certain commodity prices thanks to a cessation of overstocking by state owned Chinese companies. The Aussie dollar has rallied substantially this year But Australia remains another great backdoor to China.