Implications of China vs. US Timespans

Introduction

A number of years ago a good friend attended a Chinese Embassy party where a very senior member of the government commented that while the West owned the watches, the Chinese owned the time. This critical distinction has stayed with me in terms of looking at investment horizons.

One Belt One Road

While there has been some US coverage of the “One Belt One Road” meeting in Beijing this Sunday hosted by Xi Jinping with Vladimir Putin in attendance, most of the US attention has been focused on the dismissal of one employee at the discretion of the President. As a long-term investor, I believe this is a misplaced focus. On the Chinese side the implications of the massive One Belt One Road Initiative may have implications into the next century. The US focus appears to be on the electoral contests in 2017-2020.

I find it is interesting that China is using a staging investment philosophy somewhat similar to our TIMESPAN L Portfolios^®. China announced some of the outlines to this the One Belt One Road Initiative in 2013. From an economic vantage point it was a brilliant way to export its excess steel and cement capacity in building long line railroads and some internal subway systems. It also would reduce shipping costs of Chinese manufactured products that potentially could be exported to 60 countries, part of the land and sea bridges.  This is somewhat like President Eisenhower's US interstate highway building program that required new federal highways to be built with the ability to handle the transportation of heavy tanks.  As the rail and port facilities are built, China (even without moving its military) will have strengthened its ability to influence all of the surrounding countries. Some have called this drive as "Globalization 2.0.” Compared to the Russian leader in attendance, the US is sending a senior director for Asia at the National Security Council. While there is definitely a military threat in this initiative, by far the bigger threats are economic and political.

The One Belt One Road Initiative is not without substantial  risks. The planned funding requires a series of public/private partnerships. Every analyst and most investors should have knowledge and respect for past histories. Around the world in the last half of the 19^th Century, there was a surge of railroad building. The British were particularly active in South America. I suspect that almost every railroad company started during this period eventually went bankrupt. In one case the largest and most powerful UK merchant bank almost went under because of its Latin American exposure. I can not think of a long line US railroad that did not enter or threatened to enter bankruptcy. Some of the same problems exist today. One of the Chinese-backed African rail lines is not expected to reach breakeven for the first eleven years, and we all know how reliable the predictions of breakeven have been. 

If we of short memory fail to remember the global distribution of less-than- healthy US residential mortgages, we could have a replay with global distribution of private partnerships through the growing power of Chinese financial services companies. Thus, for the global investor there is both downside and upside as this initiative grows. I maintain that no matter what you invest in; stocks, bonds, commodities, real estate, currencies, or intellectual property, your returns could pivot on what is happening or rumored to be happening in China.

What are the US Markets Focused On?

Investors into the US market are focused on the very short-term to intermediate future while China is exercising its long-term options.

The following are briefs tidbits that have crossed my computer screens this week:

1.  Dow Jones Industrial Average - A minuscule decline closed on of the two price gaps in its current chart. The other two major stock indices, S&P 500 and NASDAQ, still have price caps. (One wise market analyst suggests that we need a 5% decline before we can resume a meaningful upturn.)

2.  JP Morgan has noted that 37% of NYSE volume is executed in the last half hour of the trading day as Index funds rebalance.

3.  There is some justification in the adage “Sell in May and Go Away.” Since 1950, the period November through April does better than the other six months, 71.64% of the time.

4.  According to its inventor, the CAPE ratio, used as a valuation measure, explained about 1/3 of the variation in the ten year returns. (Surprisingly this is roughly the same chances of a favorite winning in most horse races.)

5.  Ray Dalio, who manages one of the largest hedge funds, sees no major economic risk in the next year or two. (This could be an important cautionary flag.)

6.  The highly respected GMO seven year prediction for real return on stocks is -3.8%

7.  Vanguard believes we are in a period of slow growth; e.g., a 60/40 asset allocation will produce a return between +3% and +4.5%. (If they are correct, which I doubt, the average foundation will be liquidating its base each year if it has a mandated 5% pay out.)

8.  Turning to the increasingly popular European investing, there are two points worth considering: (a) the current price of the Stoxx 600 Index is where past rallies have peaked out, and (b) over half of the ETF flows into non-domestic funds came into three Index funds and these were somewhat smaller than the ETF redemptions in two domestic Index funds. (These suggest to me that main players in the ETF market are trading-oriented, and may not be patient during surprises.)

Investment Conclusions

Despite the reputation of highly speculative retail Chinese investors, the Chinese government is playing a long game.

The US market is increasingly short-term focused. This may, over time, give us longer term investors a bigger barrel to fish in.

As we structure various markets I am wondering whether our assorted valuation measures need to be adjusted due to fundamental changes in supply and demand.

Any thoughts? 

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Investment Traps: More Evidence

Introduction

Last week’s blog suggested that the surge of Friday, June 29^th could have been a trap for unwary investors. There were three different baits in the trap. They were the relief caused by the US Supreme Court’s decisions on Obamacare, the surprise and pleasure that the latest European summit led to some agreements on loans to troubled banks, and favorable market enthusiasm and market volume. Today we examine each to see whether they are baits or poisoned fruit.

The Supreme Court did not provide needed answers

This is a blog for investors that have substantial, for them, investment portfolios; not for lawyers nor politicians, even though they have been known to have large portfolios from their private sector investing. The implications going forward are that there will be a tax that some wish to call a penalty. (Aren’t all taxes penalties?) The Court’s focus should be interpreting the US Constitution and the conflicts between state and federal law, not to make overt economic judgments. Nevertheless, the decision that taxes or penalizes people for not buying medical insurance has large and unknown economic impacts.

More to the point, I have little confidence in the supposed results of Obamacare. The annual costs to society will be large and disruptive, creating uncertainty in the reactions of individuals, businesses and the medical world. Thus far I see nothing that will lower the society’s cost or more importantly, improve the quality and quantity of healthcare. From an investment viewpoint the Court’s decision leaves open the impact of its actions and thus makes it easy to continue the indecision on the part of employers to hire employees. Over time I suspect that it will lead to more work being put out to small contractors that have exclusions in the present regulations. Bottom line, I see no reason that the markets should rise on the basis of the decision. 

Summit agreement is illusory

By the end of the day Monday, we will learn from the meeting of finance ministers in Brussels how they are going to create a single European bank supervisor. This is not a trick question but a trick that Germany played on the supposed agreement to allow the European Central Bank fund to grant loans directly to banks. This single supervisor would supervise the safety and soundness of all banks in the seventeen countries that use the lamented Euro and by implication all banks in the other countries within the European Community, e.g., the UK. With both the Finnish and the Dutch governments looking for specific collateral and other terms, there does not appear to be much confidence in the existing financial statements of at least some banks. In voting their support for these loans, the German legislators insisted on one of their pet projects: a European (and from their viewpoint, global) transactions tax. London is having enough trouble holding on to its prominence as a financial center with the growing LIBOR scandal that would prevent it from buckling under any continental scheme in the foreseeable future.  The highly respected but controversial economist from Citigroup, Willem Buiter, is quoted as saying “the EU summit measures still fall far short of what is ultimately needed to ensure survival of the Euro area.”

Read with skepticism and believe it won’t happen

I wonder whether we will see the burial of the “Too Big to Fail” concept and recognize the inevitable; that while painful in the long run, it is cheaper and more efficient to let various banks go under. Their smaller replacements will be sounder. I am probably too premature, but the odds are improving every day that this historic approach is still the best one.  I recognize that letting banks fail could in turn lead to some governments defaulting, perhaps as in the past after extraordinary attempts to inflate their way out. After inflation eventually comes deflation; either quickly or agonizingly slowly as in Japan. The lesson from distressed investing is that the quicker the filing for bankruptcy, the smaller the losses sustained by the creditors.

Probably all or nearly all of the summit participants will fight against the fundamental recognition of the structural problem. Thus the ministers in Brussels may find a way to paper over these issues on Monday, but confidence is once again low. (Even if gold drops to a bottom of $1200 an ounce before a subsequent rise as some predict, the trading loss will probably be less than holding so called high-quality paper, the principal reserve element in lots of portfolios.) 

Market mechanisms no longer favorable

On the 29^th the reported volume on the New York Stock Exchange was 4.1 billion shares. This week the average daily volume was 2.7 billion shares, or a retrenchment of more than one-third. After Friday’s release of US jobs numbers, the lack of enthusiasm was palpable; pundits were stating that we have entered a stall speed. Experienced pilots and other flyers know that crash landings are probable in a stall unless there is rapid acceleration. 

We are seeing an increasing number of money market funds as well as hedge funds leaving the business. I am also seeing a small number of active equity funds being replaced by their shareholders or management companies with Index funds or ETFs.

To some degree all of this bearishness is a good sign. Bull markets begin when almost all are discouraged. Based on the past however, we need to see capitulation which we have not yet seen. We might if interest rates were higher.

Please share with me your views as to the opinions expressed.

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