Monthly Archives: October 2009

The “New Normal” (lll): what about stocks?

October 9, 2009 By in Asian economic development, Current Market Thoughts, Recent Market Action, Strategy Tags: , , , , , , , Leave a comment

Stocks have no place in PIMCO’s “New Normal”

In the world of the “New Normal,” stocks appear to have none of the return potential they have had over at least the past fifty years.  Their returns, at about 5% annually, will be little better than one might expect from government bonds.  Although a key feature of NN, the explanation of why stocks will do so poorly vs. their past performance isn’t really fleshed out.  What little justification there is contains a number of clearly incorrect assumptions.

Yet the New Normal has gotten a lot of favorable publicity.  And the premier bond house in the US appears to believe it.

The (strange) argument for this point of view

For what it’s worth, the “New Normal” argument for low stock returns is as follows:

1.  economies around the world will have nominal growth of about 3% annually for an extended period of time.  There will be no exceptions.  Previously fast-growing emerging countries have based their expansion on exporting to the US; they will be unable to find a substitute source of growth and will, therefore, stagnate.

2.  a country’s stock market mirrors its GDP, meaning corporate profit growth and stock market gains don’t exceed the rate of GDP expansion by very much.   Therefore, the argument goes, stocks are unlikely to have nominal returns of more than 5% per year.  What country’s GDP?  Unclear, but it really doesn’t matter much, since no place will be growing.

3.  since stocks will offer limited scope for capital gains, investors should concentrate on dividend-paying equities.

That’s it.

The conclusion seems to me to be much too pessimistic about stocks, even if the NN’s bleak assumptions about world economic growth prove to be well-founded.

Where it goes wrong

Where does the NN analysis of equities go wrong?  –in a number of places.  But the key one, I think, is the belief that the stock market mirrors the GDP of the country where the stocks are traded.

How is this incorrect?

Only the best and the brightest are publicly traded, not the whole economy

Any country has a number of corporations, partnerships and sole proprietorships that make up its corporate sector.  Generally speaking, only the strongest, most profitable and fastest growing firms satisfy stock exchange listing standards and also generate enough investor interest to launch a public offering.  New firms are typically brought to the market, and added to representative stock market indices, on a regular basis.  Older, flagging, firms are routinely eliminated from the indices and sometimes delisted entirely.  In other words, stock markets tend to feature the best and the brightest, not mirror GDP.

Not all sectors are in the stock market…

It’s common around the world for large chunks of the local economy to have little or no stock market representation.  In the case of the US, for example, it’s hard to find any sign at all of real estate, construction or, nowadays, autos, among publicly traded equities.

This fact is also clearly illustrated in Europe.  The largest economy in the EU, by a margin of about 25%, is Germany.  The UK and France are more or less tied for second place.  Yet the London stock market has been, for at least the thirty years I’ve been aware of it, several times the size of Frankfurt’s.

…and not all markets limit themselves to one country

Very little of Germany’s GDP is listed.  In contrast, partly because of its colonial past, London is home to a large number of global companies, much of whose business lies outside the UK.

Hong Kong is another example.  Nowadays, its importance comes from the mainland Chinese firms listed there, not the local banks and utility companies.

The US market is still another.  At least a third of the S&P 500’s revenues come from abroad.  A significant number of NYSE companies are actually global enterprises whose primary listing is elsewhere, but who trade here through American Depository Receipts.  Many foreign firms also trade on the “pink sheets.”

S&P profit growth has historically been way ahead of US GDP growth

Again, regarding the US, Bloomberg recently reported that profit growth of the S&P 500 averaged more than six times the growth of  US nominal GDP over the past sixty years.   (This may be somewhat of an apples-to-oranges comparison, since many S&P 500 members have large non-US operations.  But one could substitute world GDP for US and still get a ratio of S&P growth to GDP growth far north of one.)

All in all, there doesn’t seem to be much empirical evidence in support of the “New Normal” description of the way stock markets work.  And there are lots of examples of stock markets working contrary to the way PIMCO supposes.

In addition, my observations are that:

Flat stock markets don’t mean you can’t make money

Some US stock market observers are beginning to liken the current period for the S&P as similar to the second half of the Seventies–in the sense that the overall market was trendless for several years but was still a stock picker’s paradise.   Smaller companies, the move to the suburbs, women taking a greater role in the workforce, the rise of specialty retailing–all these were ideas that led to stocks that generated spectacular profits.  This was the heyday of the Fidelity Magellan fund, as well as of many small capitalization specialists.

Difficult times have in the past also been sharp spurs to innovation.  I keep coming back to think about laid-off exotic metals scientists at the end of the Cold War who used their skills to create the modern golf club industry.

What might today’s trends be?–maybe Gens X and Y, commodities, emerging markets exposure, tourism, evolution of the internet, netbook/smartphone.

Will the rest of the world just lay down and die?

No one knows.  But why would it?

We can observe that in the post-WWII era emerging economies have had a very difficult time in turning from export-led growth to expansion based on cultivation of domestic demand.  What we don’t know is what role the continuing voracious appetite of US consumers for imported goods has played in this difficulty.

If we argue that events follow the path of least resistance, it’s even possible that emerging economies have failed to mature because the US consumer has always been there.  It could be that, with the US consumer absent, emerging economies will make surprisingly strong progress in rebalancing GDP.  Certainly, both China and Brazil have already recently made dramatic economic changes in short periods of time.  It may turn out that those who argue for global economic stagnation have just misidentified the stumbling block to emerging nations’ progress as being one of political will rather than external circumstances.

How could adherents of the New Normal not have a better grasp of what stock markets are and how they work?  I guess we live in an age of heavy asset-specific specialization and the NN people know about as much about stocks as I do about bonds.  But from where I sit, the risks in holding stocks are about what they always have been.  Bonds, on the other hand, have lost the appeal of the secular decline in interest rates we have had worldwide since the early Eighties.  Given, also, that there are so many bond believers convinced that interest rates cannot rise, bonds seem to me particularly vulnerable to any signs of economic growth.



Wynn Macau (ticker: 1128) trading begins; implications for LVS Macau

October 9, 2009 By in Current Market Thoughts, Hong Kong, Recent Market Action Tags: , Leave a comment

Wynn Macau, ticker 1128, began trading in Hong Kong today in a flat overall market.  The initial day gain of 7%, while modest by traditional Hong Kong standards, is  sharply with the failure of a series of recent IPOs in the Special Autonomous Region.

This is especially good news for Las Vegas Sands, which plans to raise US$ 2 billion before yearend by listing a portion of its Macau subsidiary in the Hong Kong market.

A poor reception for the Wynn offering would presumably have meant a lower price for LVS.  I don’t think would have called off the IPO, however.  As reported in an 8-K filing with the Securities and Exchange Commission in the US, on September 4th LVS “prefinanced” US$ 600 million of its IPO proceeds through an unusual convertible arranged through Citicorp International.

The terms:

1.  The bonds, which mature on September 4, 2014, earn interest at the rate of 9% for the first year, 12% for the second and 15% for the final two.

2.  They are exchangeable into shares of the LVS Macau listing at 90% of the IPO offering price.

3.  They are callable by LVS starting 30 days after the IPO.  The holders of any bonds called, however, must be issued warrants that give the holders the right to buy the same number of LVS Macau shares, at the same price, as if they had exchanged the bonds for shares.

4.  Holders can put the bonds back to LVS during a specified period in 2012, but lose their right to warrants if they do so.

One notable feature of the bonds is what LVS agreed to pay to get immediate access to money that would presumably otherwise be available in 60 to 90 days through the IPO–effectively US$67 million worth of stock in LVS Macau at the IPO price.  Another is that they can’t be called, and the borrowing repaid, until after the IPO.

The “New Normal” (ll): how things could turn out differently

October 7, 2009 By in Asian economic development, economics, Strategy Tags: , , , , , , , Leave a comment

The “New Normal”

The “New Normal” is shorthand for an economic forecast that concludes the world will have unusually slow growth for an extended period of time.  According to NN, the US will struggle to repair itself from the financial crisis and the rest of the world will search unsuccessfully to find some other source of growth than selling things to the US.  Full details of  the “New Normal” forecast, championed by the bond manager PIMCO, can be found in the first post in this series.

PIMCO’s conclusion:

invest in (shorter-term) bonds and in dividend-paying stocks (no indication about industry or geographical focus of assets and earnings [although to pay dividends to US holders, a company must have money available in the US]).

What the NN assumes

I’m not sure the “New Normal” is the highest probability outcome for the world over the next few years.

Maybe events will turn out this way.

But NN depends on the idea that countries like China will be unable to shift their focus from exports to the US to trading with each other or to building up their domestic economies –this, despite the fact they realize the present export-oriented growth model won’t work while Americans are refusing to spend.

Does this make sense?  Should we bet on the NN?

As a stock market person, this last part troubles me.

For one thing, post-WWII China has been an almost continuous–and many times bizarre–petrie dish for social changes, as Jonathan Spence has recently outlined.

Maybe they can’t turn on a dime again.  And it’s true that elsewhere the record is mixed.  Tiny places like Singapore and Hong Kong, as well as Brazil and Mexico and an older generation in Japan, have made dramatic alterations to their economies in relatively short periods of time when they needed to.

On the other hand, today’s Japan, Korea, and almost any natural resource-rich country you may care to name, have not.

What really bothers me, though, is having to depend on the other guy knowing what he needs to get done and yet failing to get it done.  In my experience, it’s better to overestimate the other guy than to underestimate him.

Things could work out differently in two main ways

Let’s assume during this post, however ,that the NN is the highest probability outcome.  How could things work out differently?

I think there are two main possibilities, and a third–highly unlikely–one:

1.  the bad outcome: the rest of the world loses faith in the US and in the dollar, either gradually or all at once.  Concern would manifest itself in some combination of two results:  decline in the dollar vs. other currencies, and a rise in the interest rate that issuers of dollar-denominated bonds would have to pay to buyers.

Though politicians in the US would doubtless wish the entire economic loss to occur through currency weakness, and thus be less clearly attributable to them, the large continuing requirement for foreign buyers to help fund the budget deficit probably means a rise in interest rates as well.

The consequences for stocks and bonds?

Higher interest rates mean bond prices decline.  They also have a negative influence on stocks as well.  In theory, dividend-paying stocks suffer less than their payout-less brethren.  But the effect of a dollar decline could be much more important than potential yield support (which hasn’t worked so well in the past year, anyway–see my posts on this topic).  Companies with large businesses outside the US, or which either compete against (now more expensive) imports or export products/services made in the US may end up with substantially increased profits.

The net result:  bonds do poorly;

stocks with foreign currency revenue streams go up in a flat to down overall market.

2.  the good outcome: the world ex US checks out of intensive care in the next year or so—or at any rate much sooner than the NN expects. Where or how the economic vigor comes from is less important than that it emerges.   This is, by the way, the verdict world stock markets have reached.

One possibility, being promoted vigorously by Goldman Sachs, is that people in the US underestimate the economic power in developing economies, which have been relatively untouched by the financial meltdown in the US and the EU.

Another is that trading partners of the US and EU adjust to the new realities faster than the “never” that the NN assumes.

A third is that the US is saddled with slow growth and chronic high unemployment, sort of like the Europe of the Eighties and Nineties, but the rest of the globe hums along nicely.

In this scenario, whatever the cause, the rest of the world raises interest rates back to normal, while the US does not.  The dollar weakens and domestic interest rates rise.  The effect on bonds is negative.

But in this case, because foreign growth is vigorous, US exports revive.  Tourists flock to Disneyworld, New York, Las Vegas and other vacation destinations.  Foreigners begin to buy up US urban and resort real estate, which looks like an absolute steal compared with possibilities elsewhere.  The infusion of foreign buying power helps the US economy rise off the floor.  Stocks generally rise, led by the same winners from the first case–those with foreign assets or which provide goods and services to foreign buyers.

The net result:  bonds go down, stocks go up–with companies catering to foreigners doing the best.

3.  The unlikely possibility: the US recovers much more quickly than anyone expects–as it typically has done in the past.

In this case, bonds go down a lot, stocks go up–led by issues focused on domestic demand.

Conclusion:  NN is an all-or-nothing bet

For a strategy of buying bonds at historically low interest rates to work, it looks like the “New Normal” had better be correct.  The US economy must have a dark-side “Goldilocks” character–not too strong, but not too weak.

It must show enough strength that foreign investors don’t worry about buying our government bonds.  At the same time, the whole world must show enough weakness that interest rates don’t rise to normal and no more attractive investment opportunities than US bonds arise.

Even in NN, however, foreign bonds may end up performing better than US bonds, although a dollar-oriented holder of the latter won’t have a dollar loss.  Dividend-paying stocks perform at least as well as domestic bonds.

If events turn out either better or worse than NN expects, bonds are a bad place to be.  Well-selected stocks do well whether NN is right or not.

Stocks may be a better bet, even if NN turns out to be right

In all three cases, there will likely be stocks that will outperform bonds.  The common threads appear to be having a dividend yield (if NN turns out to be right) and selling to foreigners as a way of combatting potential weakness among domestic consumers or in the dollar (if it doesn’t).

PIMCO argues that stocks overall will return about 5% per year in a “New Normal” world.  Their reasoning, however, contains a basic error that biases their number downward.  More about this in my third NN post.

Note: While I’ve been writing this post, the Reserve Bank of Australia has raised interest rates there, citing the recovery in Asian economies, notably China.  See my post dated today on the subject.

Reserve Bank of Australia raises interest rates by a quarter-point: what it means

October 7, 2009 By in Current Market Thoughts, Recent Market Action, Strategy Tags: , , , Leave a comment

The one rate rise, of itself, shouldn’t mean much.  Despite this, the fact of the interest rate rise was widely covered in the financial press.  Many attributed the subsequent rally in European and US stock markets to the “positive” signal the increase, the first by a G-20 country, was purported to represent.  The idea presented was that other G-20 countries would doubtless be soon to follow.

Yes, the Reserve Bank of Australia’s move an encouraging sign, but not the kind that market commentators have been describing.

Australia, once seen merely as the successor to Argentina as the “Lucky Country,” is a thriving,  macro-economically well-managed place.  The RBA is highly skilled and well-respected.  But Australia is not a typical industrialized country along the lines of the US or the EU.

Australia has a land mass roughly equivalent to the United States’, but only about 6% of the latter’s population.  Partly because labor has always been the scarce factor of production, partly because its geographical isolation means high shipping costs, partly because it bought, hook line and sinker,  the colony scam perpetrated by Great Britain (“you focus on producing raw materials that you sell me at a low price and I’ll sell you finished goods at a high price”), the Australian economy is highly focused on trade in agricultural, and energy and other mining commodities.

Australian exports, for example, amount to about a quarter of GDP there, vs. about 7% for the US.  The country’s major trading partners are in the Asia-Pacific area.  Japan, China and Korea are the top three.

The interest rate rise is not because the domestic economy was sick, has now healed itself, and–by analogy–the rest of the G-20 will soon follow suit. It’s because the export business is picking up.

The reserve Bank of Australia makes three points in its press release explaining the rate rise:

1.  the global economy is resuming growth;

2.  recovery will likely continue in 2010;

3.  “Prospects for Australia’s Asian trading partners appear noticeably better…For Australia’s trading partner group, growth in 2010 is likely to be close to trend.”

The RBA move is good news:  it’s good news for Australia, for Asia, for emerging markets and for commodities.  There will doubtless be a rub-off effect of this growth on the US and the EU.  But it’s not a sign that all is well in either of the latter two areas.

Oil priced in a basket of currencies, not the US dollar?

October 6, 2009 By in Current Market Thoughts, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , Leave a comment

The British newspaper The Independent published a report today of negotiations among China, Japan, Russia and France and Middle Eastern oil producers to transition the pricing of oil from US dollars to a basket of non-US currencies over the next nine years.

Although the Saudis have denied the report, the article is quite detailed and the paper claims to have confirmed the story with banks in Hong Kong and the Persian Gulf.  My experience with accounts like this is that in the US they end up being completely false, but in other countries they tend to be fundamentally correct, though with the details sometimes only roughly true.

A movement like this would also make economic sense.  It would diminish the role of the US dollar as the world’s reserve currency–a political goal of mainland China, France and Russia.   More important economically for the countries involved, it would eliminate the vagaries of the dollar from the pricing equation and stabilize the real value of the commodity.  It also indicates, of course, the expectation of a smaller role for the US and for the dollar in future world commerce.

The article also mentions gold as a temporary part of the basket–presumably the reason for the rise in the gold price today.

To me, the main message of the article is that the world is farther along than I would have thought in planning to retire the US dollar as the global reserve currency.  The near-term implications are, I think, a somewhat weaker dollar.  In the longer term, though, this would imply limits, possibly severe limits, on the ability of Washington to run a budget deficit with impunity, as well as higher domestic interest rates.