Sustained Fiscal Stimulus: A Road To Eternal Boom Or Idiocy Of Hope

I recently returned from a trip to Japan, but there is little new I can say about its economic situation. In fact, in some ways Japan reminds me of Thailand – there is nothing exciting about its economy, and the only exciting thing about the country is its nightlife. However, investors should remember that there are many factors other than GDP growth that affect stocks, bonds and currencies. So, while I am not excited about Thailand and Japan economies, I do like their stocks – I see decent dividends and limited downside risk in Thailand stocks (however, some stock or sector picking might be required), and I like Japan stocks purely from a contrarian point of view. Japan stocks have been in a secular bear market for two decades and there is little (especially bullish) interest in them.

The real reason I am mentioning Japan is that my trip there reminded me of an interview with Richard C. Koo that I read some time ago (the full interview is available at http://www.zerohedge.com/sites/default/files/Wheeling%20@%20Weeden.pdf). The focus of the interview is Koo’s “fascinating and unconventional” observation on differences between cyclical recessions and “balance-sheet recessions”:

The key difference is that in the typical cyclical recession, private sector balance sheets are not badly affected and people, at the most fundamental level, are still forward-looking. So, when you bring interest rates down and people are still trying to maximize profits, there will be some response to those lower interest rates. People borrow money, they purchase something and the economy starts moving forward. … [in balance sheet recessions], after an asset pricing shock, after a bubble bursts, the private sector’s balance sheets are under water. When that happens, the first priority of people in the private sector becomes to minimize debts instead of to maximize profits and if there are enough underwater balance sheets around, even if you bring interest rates down to zero, still nothing happens. People with balance sheets under water won’t be increasing their borrowings and there will not be too many willing lenders to those guys, either. So the effectiveness of monetary policy goes out the window, exactly as happened during the Great Depression in the U.S. and in Japan during the 1990s — and as is happening in the U.S. this time around. It’s a case of actions that are perfectly rational on the micro level turning disastrous when engaged in at the same time by an entire economy.

Mr. Koo then explains benefits of “successful” fiscal policies of the Japanese government over the last 20 years (Japan’s GDP didn’t crash during its recession which started in the 1989 and, according to Mr. Koo, Japanese private sector stopped deleveraging in the 2005) and gives us his magical cure for the “balance-sheet recessions”:

The private sector must repair its balance sheets before outsiders find out how bad its financial health actually is. In order to retain credit ratings and so forth, the private sector has no choice. It has to repair its balance sheets by paying down debt. My argument is that, if the government did nothing to counter this situation, the economy would shrink very, very rapidly. Debt repayment and the savings of the private sector would end up stuck in the banking system because there would be no borrowers even at very low interest rates. So the economy will be losing demand equivalent to household savings plus corporate debt repayment each year. That is how I think the U.S. got into the Great Depression in the 1930s. But the ray of hope here is that if the government comes in and borrows the money which now is just sitting in the banking system and puts it back into the income stream through government spending, then there’s no reason for GDP to fall. That’s what is needed in times like this, when the government cannot tell the private sector not to repair its balance sheets.

Firstly, I find Mr. Koo’s ignorance of economic theory truly remarkable, but unfortunately, the same can be said about most modern-day economists. The Austrian School of Economics has long maintained that every credit expansion must eventually lead to over-investments and then to breakdown and debt deflation, and every major book on the business cycles at least mentions the monetary theory of the business cycle. In Inflation (London, 1933), Irving Fisher claimed that

…if liquidation, for some reason, gets into a stampede, it wipes out (i.e. deflates) credit currency, which lowers the price level and reduces profits, which force business into further liquidation, which further lowers the price level and reduces profits, which force business into further liquidation – and so on and on: a tail-spin into depression… We now come to the paradox that if the debts get big enough, the very act of liquidation puts the world deeper in debt than ever… Each dollar represented in the unpaid balance grows faster than the number of the dollars is reduced by liquidation. Such is the essential secret of a great depression.

Although I wish today’s economists had a bit more knowledge of economic theories (or had more moral integrity), I would rather like to focus on Mr. Koo’s recipe for solving the problem of debt deflation. I would like to remind readers of an argument put forward by W. Ropke in Crises and Cycles (London, 1936):

The credit expansion setting of the boom going proceeds by way of the interest rate being “too low”. The too low interest rate invites a general increase in investment which then leads to the mechanism of the boom drifting on towards its ultimate debacle… The expansion of credit in the boom expressing itself in the too low interest rate leads to an over-expansion of the economic process and by introducing a general over-investment disrupts the equilibrium of the economic system. It allows more to be invested than is saved and makes available the necessary increase in money capital from credits which do not originate from savings but are created out of nothing through the banking system… The demonstration that the credit expansion of the boom leads to over-investment provides at the same time a proof that the capital formation induced by credit creation, and the extension of production that it sets going, lead to a painful reaction expressing itself in the crisis and depression. This reaction can indeed be postponed by a further increase of the credit supply but only at the price of a corresponding aggravation of the ultimate reaction. An “eternal boom” is therefore out of the question. (Emphasis added)

This reaction of debt deflation has indeed been something that has continually been postponed in the United States since the WWII – while a buildup of the leverage has always been associated with economic expansions, the government policies provided support during cyclical recessions. This prevented frequent depressions associated with the pre-WWII period, but at the same time, the balance sheet imbalances were never fully unwound. As the leverage in the system grew, so did grow the threat of debt deflation and the pressure on the government to reflate the demand no matter what. However, an “eternal boom” is out of the question – as the consumers and the companies took more and more leverage, they required increasing support from the government policies, as is seen from the recessions becoming increasingly severe and being triggered at lower and lower short-term rates. It appears that we have finally reached the zero-hour, when no matter how low the interest rates are, the private sector is no longer willing to increase its leverage.

Mr. Koo claims that debt deflation in private sector can easily be solved by more debt inflation – only this time in public sector. However, the question is what will happen after this last piece of ammo in government’s hands is expended. Mr. Koo’s assumption is that the public debt inflation will allow us to get over the current recession and we can expect continuation of happy times afterwards. As I mentioned above, he points to Japan as an example of a country that successfully survived balance-sheet recession by sticking to this cure. My main objection to this argument is that Japan’s problems are anything but resolved – the private sector debt has simply been replaced with the huge public sector debt and we can only guess what the future will bring. While one must acknowledge that there were countries in the past which have successfully reduced its public sector debt through massive spending cuts (Canada is an example, although a bull market in commodities certainly helped in that case), I find that scenario unlikely either in the Japan or the U.S. case. The demographic pictures of both countries are rapidly deteriorating, interest payments alone will make it hard to reduce debt, and growth prospects of both economies are weak. It is thus a more likely scenario that the next recession will trigger a complete collapse of the system and will finally purge all the excesses that have built up over the last few decades.

While the next recession is probably a couple years away, it is likely to be at least comparable to the Great Depression and investors should thus start preparing for this scenario. I don’t advise shorting the market (at least not yet), but rather advise to think about what the governments usually do when the system starts collapsing – they nationalize retirement savings, and enact exchange and capital flows controls (I will skip the issue of wars for now). Most investors believe this could never happen in the U.S., but one only needs to look at the history to see that it has happened to many great empires in the past – everything changes, and one should never become complacent. The fact is that investors’ assets are becoming increasingly unsafe in the U.S. and they should take actions to mitigate this risk. I realize that an overwhelming majority of investors think that even suggesting this scenario is crazy, and that advising them to reduce or stop 401K payments and move their cash and assets overseas would be a waste of energy, but at the very least, I would advise everyone to open a non-US bank account and make sure they can easily wire their cash to this account. This requires minimal amount of energy and money, and it will provide at least some security in case of emergency. Opening an overseas account can take some time and research, and once the collapse starts, it will be too late to do this (this is especially true for the U.S. citizens since fewer and fewer institutions are willing to accept them as customers). More bearish investors are advised not only to limit their exposure to U.S. securities, but also to make sure the custodianship of their non-U.S. securities is with entity that is not in the U.S. jurisdiction.

Dangers Are Increasing

As our readers know, our baseline scenario for this year is fairly flat market, with increasing volatility and narrowing breadth. Although the economic improvement in U.S. is very weak, and equity prices have increased substantially driven on the wave of liquidity, which is unsustainable over the long term, we feel that downside is limited due to still fairly easy monetary conditions, raising profits, and the fact that Obama/Bernanke duo would easy monetary conditions further and/or enact another stimulus package if S&P 500 falls below 950. However, in the recent weeks, several factors are threatening our baseline scenario:

• Chinese economy is booming at unsustainably rapid pace and policy makers started withdrawing stimulus. New policy tightening measures are announced on almost weekly basis. While we see these pre-emptive measures as good for long-term growth, they pose threat for both equity and commodity prices.
• The Fed is scheduled to stop purchasing mortgage-backed securities at the end of March, while the U.S. housing is still extremely weak and inventory is at very high levels. Relapse in U.S. real estate prices is not out of the question.
• Euro area policy is overly restrictive for most European periphery countries. Greece is on verge of debt default, and both bailout and non-bailout scenarios could sow the seed of euro meltdown or at least significant weakening. A weaker euro essentially tightens monetary conditions in the U.S. and Japan.
• The Fed moved to hike the discount rate from 0.5% to 0.75%. The effects of the discount rate hike are basically non-existent as discount window borrowing is at a mere $14.9 billion (compared with the pre-crisis levels of $110 billion) and commercial banks are sitting on a $1 trillion cash hoard, however this might signal a change of policy and more tightening measures might follow sooner than we anticipated.
• Sentiment against big government spending has increased significantly, with Tea Party movement gaining more ground (although from very low levels), support for Obama’s policies waning, and Democrats loosing super-majority in the Senate. This could pose significant headwinds for any further stimulus packages.

Nonetheless, these sources of uncertainty will likely be resolved in the coming months, but until such time, investors should be alert and more nimble than usually.

Capitalism In North Korea
It recently came to our attention that Premier Kim Jong-il sacked his top monetary official, Pak Nam-gi for hyperinflation in food prices, caused by failed currency reform at end of last year. Marcus Noland, of Peterson Institute for International Economics, explains what happened:

In principle, currency reforms are not a bad thing. […] The North Korean case is significantly different from the conventional case in that the move was sprung on the populace without warning, and most critically, enormous limits were placed on the ability to convert cash holdings, in effect wiping out considerable household savings and the working capital of many private entrepreneurs. Citizens were instructed that they had one week to convert a limited amount of their old currency to the new currency at a rate of 100:1 (i.e., one new won would be worth 100 old won). The limit would not finance much more than a 50 kilo sack of rice at prevailing retail prices. 

The announcement set off panic buying as people rushed to dump soon-to-be-worthless currency, buying foreign exchange or any physical good that could preserve value. As the value of the North Korean won collapsed on the black market, the government issued further edicts banning the use of foreign currency, establishing official prices for goods, and limiting the hours of markets and products that could be legally traded. 

As social opposition to these moves began to manifest itself, the government was forced to backtrack, offering compensatory wage increases, sometimes paying workers at the old wage rates in the new currency, amounting to a 100-fold increase in money income. The result has been a literal disintegration of the market, as traders, intimidated by the changing rules of the game, withheld supply, reportedly forcing some citizens to resort to barter.

Food shortages, civil disobedience, protests and fighting in the streets intensified. As governments saw situation getting out of its hands, scapegoats were chosen, market regulations were lifted, use of foreign currency was once again allowed, Premier Kim Jong-il issued an unprecedented public apology, arrested money changers and illegal traders were freed, and jangmadangs (open-air markets) are once again returning to normal.

I’m in no way suggesting that North Korea is becoming next haven of free-market capitalism, as that might be years or decades away (readers should remember that attempts of freeing economy were already made in mid-1990s only to be reversed in 2004). I merely wish to highlight that no matter how many times governments around the world and through the history attempt to over-regulate and over-control the economy, starvation and bad living standards will always force the population to turn to black markets, both in currency and in goods. In fact, the existence of black markets in some sector of economy is the best indicator of unsustainable government regulations (gold during the Great Depression, alcohol during the Prohibition, various currencies through the history, and drugs at the present time).

While waiting for North Korea to open up, we encourage our readers to get some exposure to Vietnam, which recently started opening up and is now where China was a couple decades ago, and to stay alert for ways to invest in Sri Lanka, which recently won the civil war against Tamil Tigers. It is often most profitable to start investing in country immediately after a major civil war or after it starts opening up its economy – economies of Peru after winning against Shining Path and of China after opening up are great examples of this. Although the journey might be bumpy and there are bound to be problems, in the long run, the economies of such countries often offer great investment opportunities.

Investment Considerations
As we mentioned above, next few months will be critical. Current correction could still have some room to run, and it is too early to bottom-fish. While we would not recommend shorting the market or getting out of strategic positions yet, readers should still “sell the strength” rather than “buy the weakness”. We continue to like some countries and specific sectors that we mentioned in the past (i.e. U.S. refiners, Japan and Japanese banks, Thailand and its tourism-related shares, Canadian energy companies) and select commodities (primarily in precious metal and agriculture sectors), we would not add to these positions at this time or would at least scale in very slowly.

Transitioning From Liquidity To Growth

Commodity strategy for the rest of the 2010 will need to take into account that global economy is shifting from liquidity to growth phrase and from expectations to reality. In 2009, we had a broad rally in commodities due to oversold conditions, ample liquidity, and expectations of strong demand from China. However, none of these three conditions hold any more – the rally in 2009 removed oversold conditions (except perhaps in some softs), liquidity is slowly withdrawing or at least increasing more slowly, and strong demand from China has been fully priced in. On the other hand, we expect to start seeing strong growth in economic economy, especially in emerging markets, increased bearishness regarding non-commodity currencies, and continuation of industrialization in China, which are all bullish for commodities. These forces will not take effect immediately, and we wouldn’t be surprised to see consolidation and increased volatility in first half of the year, as we transition from liquidity driven rally to rally based on fundamentals. Breadth will almost certainly deteriorate, and picking the right commodity sectors will be critical. We favor precious metals over base metals, tactical plays in energy sector, and non-grain softs.

Base Metals
The LMEX Metals Index doubled last year due to ample liquidity, dollar weakness, rising global leading economic indicators and Chinese stockpiling. However, LME metal inventories are at a cyclical high and exports from Asia are just starting to recover. This suggests that a major chunk of economic recovery has already been discounted and base metals should lag precious metals.

It is important to note that at this stage of the cycle, growth-sensitive sectors such as base metals should take leadership from liquidity/defensive sectors such as precious metals which should start to underperform. But it seems that this time might be different, as base metals have anticipated the growth rebound, and both price and inventory levels increased dramatically during the liquidity stage in 2009.

From absolute return point of view, we are neutral on base metals in the first half of the year. While net speculative positions as share of open interest have almost reached complacent levels last seen in 2008, the bullish sentiment and the level of open interest are still far below the 2008 highs. The biggest risk is Chinese tightening, which could cause hard landing for Chinese economy and base metals. However, Chinese policy shift is occurring at a time when price inflation is tame and when exports are expected to surge. It is more likely that Chinese policy tightening will cause problems in real estate sector in eastern provinces, but will not cause a hard landing for the overall economy. In the second half of the year, strong growth, relatively generous monetary policy, and secular bull market in metals should push base metals higher.

Copper, lead, and mining stocks remain our favorite plays in this sector, but there might be a better entry point in next few months. We are long-term bullish on Zinc and aluminum, but they are extremely energy-sensitive (energy accounts for 43% of zinc production cost and 41% of aluminum production cost) and their price might be “pegged” to coal until bullish secular trends start taking over.

Precious Metals
Low interest rates, escalating problems with government debt around the world, availability of gold ETFs, and emerging market jewelry demand, and tight supply continue to provide tailwinds to gold on strategic horizon. Desire of Asian central banks to diversify out of the dollar (central banks have turned to net buyers for the first time since mid-1970s) also provide support to gold prices. On shorter time horizon, interest rate expectations and raising dollar due to trouble in Europe could keep gold in $1000-1050/ounce range. However, the Fed will not start withdrawing liquidity in next couple of years, and we expect gold to continue its uptrend within next couple months.

Strategic positions should be held, but we have liquidated high-beta plays such as gold miner shares in mid December and re-entry into these positions might be premature. Net speculative long positions relative to open interest have fallen below their highs, but not yet to a level which would eliminate “stale longs” and coincide with intermediate-term bottom. We would also like to note that gold has fallen below its support of $1075 in first week of February, which should have triggered a lot of sell stops; however, it immediately bounced back which might indicate that “smart money” is buying and might indicate that intermediate-term bottom has been reached. This bullish reversal poses a threat to our base scenario (of continuation of correction) and it might be prudent to start slowly scaling back into high-beta plays.

Energy
In the long term, oil and energy prices (except perhaps natural gas) are certain to increase significantly, due to extremely easy monetary policies and declining oil production. However, in the intermediate term, we have very little conviction on the direction of energy prices and prefer to stay on the side in this sector.

We do however, still like being long distillate cracks through refinery stocks. We expect to see increased U.S. import volumes, which will in turn increase trucking activity. In fact, the Trucking Tonnage Index is already firmly off its 2009 bottom (this is the key indicator of distillate fuel use).

Softs
Prices of all agriculture commodities have become extremely depressed in beginning of 2009, and they have underperformed other commodities since. We are especially bullish on non-grain softs (coffee, cotton, livestock, and sugar) where fundamentals are extremely strong:

• Cotton stock-to-use ratio will be at 15-year low by July 2010; in addition, we are seeing strong demand recovery from China, India, and Pakistan (which account for approximately 70% of world cotton consumption)
• After two consecutive years of crop disappointment in India and problems with crop in Brazil, sugar stock-to-use ratio is at 50-year low. We are also seeing raising demand from other consuming countries which might push sugar significantly higher. The main question remains whether we will have enough sugar to get to the next season or not. While we are holding our strategic positions in sugar, we believe that risk/reward of adding to positions at current levels is not high enough.
• Coffee stock-to-use ratio will fall to the lowest level or record in the next few months. At the same time, Great Recession has limited impact to coffee demand, due to strong consumption growth in emerging markets.
• Calf production this year will be the smallest since 1994 and cattle inventories will be the smallest since 1975. In addition, we should be seeing increased demand due to economic recovery.

Unlike fundamentals for coffee, cotton, livestock and sugar, fundamentals for grains are relatively bearish. Inventory levels are ample, and supply in 2010 will increase. On the other hand, grain prices remain extremely depressed by historic standards and any unexpected weather or increased demand from livestock producers (due to increased demand from expanding middle-class in emerging markets) could push them up significantly. Overall, we are slightly bullish, but would keep our sell stops extremely tight.

China Real Estate – What Bubble?

Inflows of foreign capital, low interest rates and a loose monetary policy have undeniably fueled the breathtaking real estate price increases in China over the last several months, however, as we argued in the past “while prices might be frothy in some Tier 1 cities, there is no systemic risk”. Nonetheless, concerns about the “bubble” in China's real-estate have continued increasing so we feel it is necessary to explain our thinking in more detail.

A “Bubble” That Everyone Knows Of
An asset bubble is an asset price that is supported by expectations of further price inflation and is not justified by fundamentals. A bubble usually forms due to a shift in the fundamentals which causes overconfidence to grow to extreme levels. During formation stage of the bubble, bearish voices are rare, and are overwhelmed by broad sense of euphoria. Explanations of tectonic shift in the fundamentals which have caused the asset price to reach a “permanently high plateau” start to emerge and full-fledged mania is created.

In the case of the Chinese real estate “bubble”, despite a significant price increase, there has been no sense of euphoria within investor, analyst, or policymaker community. Number of articles about the real estate bubble in China started to increase in the 2007 (from under 50 articles) and reached close to 150 articles in the 2009. Chinese authorities have a long standing policy of pre-empting price excesses in the real estate sector and various restrictive policies have been adopted in previous few years. There is a strong sense of price manipulation by developers and of unsustainably high prices within the investor community and in the household sector (however, although the desire of households to buy homes has been steadily decreasing since the 2004, the number of transactions has been steadily increasing, which might signal that structural forces have created demand inelasticity; more on this below). In other words, manic forces and herd mentality, which are critical elements leading to asset bubbles, are not present in the the Chinese real estate market.

A “Bubble” Without Lending Frenzy
Another important feature of asset bubbles is that they are typically accompanied with lending frenzies. As investors experience price appreciation, they typically lever up to increase returns and thus further massively inflate the bubble. As the mania eventually turns into a panic, deleveraging forces the speculators to liquidate which causes a total collapse in prices. Savings-driven bubbles are also possible, however, a collapse of savings driven bubble poses only minimal systemic risk as the price downside is much less dramatic, the increase in NPLs is not large, and the lack of deleveraging means that other asset classes are not significantly affected.

In the case of the Chinese real estate market, debt’s role is much less significant. Banks’ exposure to property developers stands at only 6% of the total outstanding bank lending and exposure to both developers and mortgage borrowers combined is currently at only 17% (compare that to 56% in the USA). Policymakers’ long-term worries of real estate excesses have made them impose very stringent rules on bank lending to the housing sector. Furthermore, banks' mortgage lending policies continue to be very inflexible; for example, mandatory down payment ratios are between 20% and 40%. The combination of these factors has caused total mortgage loans to be at mare 17% of the household deposits. In conclusion, the huge price increases in the Chinese real estate market over the last 10 years have primarily been fueled by the massive household savings and the retained earnings of developers. 

Supply And Demand Fundamentals
It is undeniable that the Chinese property prices have gone up tenfold over the past 20 years, but it is important to consider this data point in the context of greatly improved standards of living in China over the same period. Over the past 20 years, the disposable household income in China has been surging and the price-to-income ratio, a much better indicator of a bubble, has almost halved.

There also exists an increasing pent-up housing demand in China – although the per capita living space in China has increased almost fourth-fold in the last 30 years, the per capita real income increased sixth-fold over the same period. As the households get richer, they have been becoming increasingly dissatisfied with their living conditions (see http://www.gallup.com/poll/15082/Homeownership-Soars-China.aspx). Also, as we mentioned above, although the percentage of people that plan to buy a house in next three months has been in clear downtrend over the last 6 years, the actual floor space sold over the same period has been constantly increasing. All this indicates almost inelastic demand for housing due to the incredible growth China has been experiencing since opening up its economy.

The fundamentals on the supply side are almost equally bullish. Although the floor space in vacant residential buildings is at the all time high, the inventory-to-sales ratio is hovering at the all time low of around 2 months (compared to 8 months in the 1997, around 6 months before the 2005 in the the US, or above 10 months currently in the US).

It is also important to note that China is still in the early stages of urbanization and more than half of the population is still living in rural regions. Due to a huge income gap between the urban and the rural population, a huge number of rural dwellers are moving to the cities every year. Combine this with the mortgage borrowing policies which are slowly becoming more liberal (mortgage lending in China began only ten years ago), and you have a very tight supply-demand situation.

Investment Considerations
In summary, while the real-estate price gains over the last several months have been rampant and could become a cause of concern if they continue, we do not find classic features of an asset bubble in the Chinese real estate sector. In fact, for investors interested in finding a real estate bubble, we suggest taking a closer look at Hong Kong real estate, which is not in a bubble yet, but has all the necessary preconditions to become a huge bubble over the next few years (investors can easily gain exposure through REITs focused on the Hong Kong residential sector).

In other news, global equity markets bounced back in early February due to being technically oversold. However, we doubt that the current correction has run its course, and investors should avoid bottom-fishing at these levels. Staying in defensive sectors and countries, avoiding shorting government debt and dollars, and being overweight the US against the emerging markets is still advised.

2010: It’s All About Capital Preservation and Finding Alpha

The 2009 was simple for investing – as long as you weren’t in cash, the US Treasuries, or the US Dollar, you did well. The resistant Chinese economy, once in a generation undervaluation of the US equities, and Helicopter Ben flooding the system with liquidity were more than enough to ensure stock market rallies across the globe, as well as continuation of the secular bull market in commodities. The 2010 is likely going to be much more complex for investing as we start the year with the equities being slightly overvalued, with some central banks already starting to tighten their policy, and with concerns about asset and real estate bubbles in China rising. While we believe probability of the S&P 500 plunging below 900 is low (Obama-Bernanke duo would ensure that more stimulus programs are passed and that rampant money printing makes cash unattractive enough to force everyone into equities and commodities, thus supporting the S&P 500, at least in nominal terms; they can basically be thought as a put on the US equity indices), we wouldn’t be surprised to see all the gains from the 2009 negated by losses in the 2010. At least for investors in the US equities that is (which gained 28% in the 2009); investors in structurally sounder economies such as Indonesia (up 163%), Brazil (up 126%) or China (up 70%) probably don’t need to have these concerns!

Major potential issues in the 2010 are Profits, China, and Treasuries.

• Liquidity to Profits. The 2009 market rally was fueled by unprecedented amount of liquidity injected into the system by central banks around the world, but this period is coming to close.  Some central banks have already started to raise interest rates and more will follow in the 2010 (although we doubt the Fed and the ECB are among them), unconventional programs enacted by central banks are slowly expiring, and impact of stimulus packages is decreasing. There is no doubt that monetary policies around the world are slowly tightening and the liquidity itself is no longer enough to support higher stock prices. It is also important to keep in mind that it is the expectation of the Fed funds rate, and not the actual funds rate, which moves the market, so even if our base scenario of the Fed not increasing the funds rate in the 2010 plays out as expected, the expectation of the rate increases could adversely impact equity markets later in the year.
  
  In the next period, strong profit growth, which we expect to surprise on the upside, is what will support the equity prices and possibly continuation of cyclical bull market in the US. Some strategists, like David Rosenberg, disagree with this view, arguing that it is normal that every percentage point of the nominal GDP growth translates into 2.5 percentage points of the profits growth; since the consensus is for 4% nominal GDP growth in the 2010, and 36% profits growth, things don’t add up.  One possible explanation of this inconsistency is the fact that the S&P 500 annualized operating earnings as a percentage of nominal GDP already more than mean reverted (from 6% in the 2007 to 2.3% in the Q3, with the historical mean being 4.2%) and are 2nd lowest in the history (with the low being at 2.1% in the 1992). We expect this ratio will start approaching the historical mean of 4.2% and the profits growth will be much higher than 10%, which is what Rosenberg’s model of 2.5% profits growth per 1% nominal GDP growth predicts. The question remains how much support to the equity prices will the profit growth offer (even if it comes above the consensus of 26%), relative to the support that extra liquidity offered until now. Even if the rally in the US equities continues, we believe it will be much weaker than what we experienced so far, and the end of the cyclical bull market is also a possibility. However, liquidity will offer some support to the equity prices at least in the first half of the year, so we remain slightly bullish.
  
  
• Fighting Imaginary Bubbles. The Chinese economy came out of the Great Recession faster and much stronger than almost anyone expected. Low taxes, relatively free economy and high savings rate probably have a lot to do with it – almost a mirror image of trends in the last 40 years in the US!  The Shanghai Composite index has gained 85% since its low in October 2008, the real estate prices have recovered strongly, and we expect a strong rebound in exports in the 1st quarter. This strength in the Chinese economy is getting more and more attention and both analysts and the government are getting worried that China is a bubble which might burst in the 2010. It is argued that two distinct triggers might cause the collapse of the Chinese economy – real estate bubble and bad loans made as part of the 2009 stimulus package.
  
  The concerns around the real estate bubble have resurfaced of late, publicized by popular media and some high-profile economists, who are warning of a massive bubble which is ready to burst and would take the rest of economy down with it. In our opinion, these concerns are not warranted, especially in the residential real estate, and while the prices might be frothy in some Tier 1 cities, there is no systemic risk. We will be publishing a more detailed report focusing on the Chinese real estate in the coming weeks, and until then we offer following thoughts:
  
  
  
  • China’s real estate market is primarily driven by the massive domestic savings rather than by the bank lending. The main difference between savings-driven and credit-driven bubbles is that the downside risk in savings-driven bubbles is much less dramatic, and there is minimal systemic risk.
  • Bubbles are normally driven by overconfidence and generally only recognized in hindsight. However, in the case of Chinese property market, there has hardly been any euphoria, and stories on the Chinese real estate bubble have been abundant in the recent years, both in Chinese and international press. There is a strong sense among households that the prices are heavily manipulated by developers and the prices are at unsustainably high levels; however, the real estate prices remain high and the transactions continue to climb, which might be a signal of the inelastic demand which is forcing buyers to buy into an ever rising market.
  • While prices of the Chinese properties have gone up tenfold in the past 20 years, this pales in comparison to the jump in the disposable household income levels. The real estate prices relative to the per capita income have almost halved in the last 20 years.
  • The vacant housing units in China have jumped to the all-time high recently, but the inventory-to-sales ratio has tumbled. The new home inventories are currently only about two months of sales, compared to eight months in the 1990s, or nine months currently in the U.S.
  
  As part of the stimulus package enacted by the Chinese government, the banking sector has dramatically ramped up lending in the 2009. According to reports, most of this lending has been “forced”, rather than being based on the free-market principles, and the majority of money went to state-sponsored enterprises. It is argued that this “forced” lending will dramatically increase the ratio of non-performing loans, which poses systemic risk to the economy. We agree that this government-sponsored lending will lead to malinvestment, and in the long term will lead to problems in the state-sponsored enterprises, but we doubt the banking sector will be materially affected. The loan-to-deposit ratio is still hovering at the record low of 68% and the NPL ratio will increase from an extremely low starting point (currently at 1.64%, compared to 24% in the 2000).
  
  While we do not believe any of these pose a systemic risk, the state is adopting a tighter policy, which itself will at least put a ceiling on the equity prices and might easily cause a material correction in the stock market. However, from long-term perspective, we are more worried about government’s involvement in the economy – while the trend in the last few decades was reduction of government’s meddling in the economy, the “success” of the government in handling the Great Recession might reverse this trend. 
  
  
• Treasuries Bubble. The only major bubble we can identify in the global capital markets is in the U.S. Treasuries – the U.S. government is running huge deficits, and will continue to do this in the foreseeable future, social security and medical expenses are pushing unfunded liabilities through the roof, and the productivity and competitive advantages of the U.S. are plummeting (the only advantage the U.S. still has is its universities, which are still the best in the world), but the U.S. Treasury yields are still hovering at the historic lows. The long-term Treasuries are anchored by the short-term rates which the Fed is still holding around 0%, and they did serve as a safe-haven during the market melt-down in 2007/2008, but it is only a matter of time before investors realize that lending money to the irresponsible U.S. government for 10 years at 3.5% is ludicrous. Once this happens, we wouldn’t be surprised if the yields shoot to double-digits and throw the U.S. economy into a depression, which would finally clean up the system (something which the Great Recession unfortunately failed to do). The problem is with the timing this play – although we are long-term extremely bearish on the Treasuries, we wouldn’t be surprised if they rallied in the first half of the 2010, due to currently extremely bearish sentiment in both the Treasuries and the dollar. For now, we remain out of this play, but continue to monitor it carefully – both because it might provide a historic profit opportunity and because it will likely trigger the Last Depression, when the U.S. financial system is finally cleaned of all its excesses and a new world order is established.

Investment Considerations
In the 2010, investors will need to be much more vigilant, unconventional, and willing to move in and out of opportunities faster than usual. The breadth will decrease, and stock picking will once again be extremely important, as well-run companies can do extremely well even if stock indexes turn south. While some countries (Brazil, Chile, Taiwan) or sectors (we like Asian real estate) might do well, the emerging markets are at a risk due to the huge rally in the 2009, the potential problems with China, and the extremely widespread bullish sentiment. Long-only strategies will likely not do very well, and it will be important to seek alpha through relative plays (some ideas include long S&P 500/short S&P banks, long crack spreads through U.S. refiners, long Dow/short NASDAQ, and long Platinum/short Silver). Contrarians should take a look at Japan, where the new administration failed to make any changes, and where the sentiment is extremely bearish. We will expand on these themes in the coming reports, but the general theme in the 2010 will be capital preservation, achieving profits from alpha rather than beta, and being nimble.