The market took great comfort in the 4Q GDP number (+8.9%) published an efficient 17 days after the end of the quarter (perhaps the BEA could pick up a few pointers). With a small improvement over the consensus of 8.7%, concerns of a weak Chinese economy have been banished from the 24 hour news cycle for the time being.

Source: Bloomberg

However, investors should probably look elsewhere for comfort.

Although China’s multi-decade economic rise is beyond dispute, China’s GDP pronouncements are more about Beijing’s economic policy thinking than a hard accounting of the sum total of goods and services produced in the PRC over a particular quarter. In my association with the Chinese markets, they have been playing this game since at least 1992 when the B share markets opened to foreign investors in Shanghai and Shenzhen.

For the next few announcements, a number too close to 8% would be signal leadership concern for a stalling economy and that a massive state intervention (a credit loosening) is imminent. A number which leans closer to double digits would signal concerns of domestic economic overheating and would foreshadow a credit tightening cycle to tame inflationary pressures. The thresholds change slightly from year to year but the game does not. China is signalling a “wait and see” stance for the time being. For Chinese provinces and municipalities which rely heavily on a bubbly property market to keep their finances in order, that message is not the one they are waiting for. Domestic demand in China is still driven primarily by investment rather than private consumption. And especially since the Global Financial Crisis, much of that investment has been skewed towards the property sector.

In the meantime, one of the “canaries in the mine” has definitely slipped off its perch. The Baltic Dry Index has halved since mid-December. Despite the name, the BDI covers shipping routes across the globe and the primary cargoes are coal, iron ore and grain. The index is subject to impressive swings because the supply of ships is fairly inelastic while demand for cargo is highly elastic That said, a 50% drop attributed to weaker Chinese demand for iron ore shipments, is not something one should ignore.

Source: Bloomberg

Australia’s “Two Speed” Economy

If China is in fact cooling its demand for iron ore in response to a general domestic slowdown, one should look at the short side of the Australian ETF, EWA. The Australian market is heavily weighted towards resources and financials and any trouble with Australia’s largest export market should show up in the market soon.

When FEZ came into the top 3 in my Seeking Alpha portfolio at the end of last week, I have to admit that I felt a little leery. After all, “the market” as defined by the mainstream financial press was still digesting the latest rehash of the slow motion market meltdown in Greek sovereign debt. Surely the system was wrong on this one.

But, when you look at the Euro Stoxx 50 components, the picture is not dire at all. Two-thirds of the index is concentrated in France (37%) and Germany (31%) (see info page here) and looking at the top holdings, these are mostly household names that will benefit from a global recovery. OK, not a hugely compelling story to get the pulse raising at this juncture in the market.

So grudgingly I swapped out of my DBB (Base Metals), which had not performed, and put the proceeds in FEZ (Europe Blue Chips) on Monday because I could not come up with a good reason to fight the system on this change. The result? From Monday close to Friday close, FEZ returned a none too shabby 4.5%.

The result is important for two reasons.

Firstly, the return was split evenly between index and foreign exchange returns. Over the four days, the index gained 2% while the change in the Euro/USD exchange rate accounted for 1.8% of the return. Forex moves are very hard to predict accurately but they are driven by investment flows and Central Bank reactions. And, as you can see in this small example, the result of their actions are reflected in the changing price and can have an important impact on returns. Is the Euro going up or is the US dollar just sinking to new lows? Probably more of the latter than the former as the US Treasury and FED talk about a strong US dollar but act as though they want to bring the value down. Does it matter? Yes, but by the time one has clarity, the market will be preparing for the next move.

Secondly, the move was not foreshadowed by some major research report or market buzz. If there was a table pounding report saying something like “Now is the Time to Buy into Euro Blue Chips”, I certainly missed it. If there was a big “Buy the Euro now” call, it did not make the mainstream financial press. The fact that these companies are soldiering on with the global recovery while their governments and Central Banks attempt to deal with the financial situation as best they can is just not very compelling financial news. It is much more exciting to concentrate on how the Greeks will default and how the True Finn party will manage to throw a wrench into any Europe wide solution.

What does this mean for users of the System?

While certainly not every switch will work out as well as DBB to FEZ did in just a few days, the purpose of the System is to provide an unemotional signal to help you keep your money working in the most promising corners of your investment universe. Sometimes, as in the case of Blue Chip Euro stocks, it is not immediately apparent. But the point of this post is that you need to let the System do its job. Often a move will happen in a market first and the analysis follows later. Waiting for everyone around you to confirm that a particular trade is a winner can be a good way to buy into a crowded trade at a high point. While we want to participate in trades for as long as there is decent momentum, we do not want to have the buy and sell decisions driven by emotions. Our very human need to travel within the safety of the crowd is one of the primary reasons why investors buy at high prices in a bullish euphoria and sell at depressed prices in a bearish funk. The point of investing is to make money…emotions just get in the way.

This week, there will be no newsletter as we are on the road in Australia.

What does Australia and year three of the US Presidential cycle have to do with each other? Usually, there would not be much of a connection.

But this year, there is a connection.

To over simplify, we are in year three of the cycle, the time when an incumbent President has to make sure the economy is as stimulated as possible so that the voters will give him another four years in the White House. As a result, it is often a good year to invest in risk assets like equities.

In this cycle, growth is coming from government spending and monetary expansion. And, while the Republicans may still get to repeat their temporary government shutdown routine (maybe they can avoid the political backlash this time), the expansionary policies at the FED are harder to stop.

That means we will continue to see inflationary money creation in the world’s reserve currency. And, since the money cannot all be put to work in the US economy, it will continue to fuel asset and commodity price growth around the globe.

How does that money get around the globe and into local economies? Primarily through Central Banks’ efforts to keep currencies from moving up against the US dollar, the FED’s accommodative policy is being exported to countries (like China) where inflationary expectations have already taken hold.

Australia is one of the places where these pressures will become most evident. As a major producer of agricultural and industrial commodities, it is a secondary beneficiary of the FED’s inflation creating policies. Not only has China’s boom created strong demand for iron ore, coal and other resources, it has also sent a wave of investment capital towards the continent sized country. This has ignited a surge in M&A activity as well as frothy real estate markets. The Reserve Bank of Australia has moved short rates about as high as politically possible (mortgages are mostly floating rate) so the next thing to go is the currency which has just crossed the 1.05 mark (FXA). If the Aussie dollar continues towards 1.10 and 1.20 as local investors expect, that’s a strong signal that one’s investments need to be well placed for an inflationary environment.

This week, for example, the base metal ETF (DBB) nudged the S&P 500 ETF (SPY) out of the top 3 in the Seeking Alpha ETF Portfolio. The main aim of the Fund King System is to track major investment flows to keep one’s money deployed in the most promising corners of one’s investment universe. Right now, it looks like major investors are positioning even more towards the inflation trade,

My buy order for EWJ was ignored on Tuesday morning. It wasn’t a large order. I was just putting it in to see if I could pick up the ETF on the cheap.

Unfortunately, I got a bit too clever on the limit (previous close less 10%) so I did not get filled. By 10am, I was pretty sure that I had missed the boat.

Why is that important?

Because the market meltdown in Japan and subsequent bounce are not being driven by rational calculations of the damage to the economy…it is just guesswork at this point. Nor is it a rational response to the nuclear power plant disaster. Our only comparable nuclear power accident scenarios happened decades ago.

It was the dramatic movement of money.

Smart Money Investors panicked and stabbed the sell button as soon as they saw their competitors doing the same. No one was waiting to see if mutual funds were going to be redeemed on the back of the shocking pictures and videos that blanketed the airwaves and bandwidth.

But, foreign investors only own about 25% of the Japanese equity market. There was only so much they could do. And once the selling pressure eased off…investors jumped in and bid the market up (both in Tokyo on Wednesday and EWJ not long after the opening bell on Tuesday).

The lesson in all this is that the weight of money can have dramatic effects on the value of assets. Japan’s “big picture” has not changed since last week. This week it is still the world’s #3 economy with an aging population, strong export sector, shocking level of government debt and extremely low interest rates. In the short term, it has sustained a mighty blow from Mother Nature but it has the institutions and experience to deal with the disaster. Fundamentally nothing much has changed. Emotionally, there have been several very big shifts.

What does the Fund King System have to say about it?

The System was not built for “Black Swan” events like this. What it can tell you is that Asia leading up to this event had some pretty crummy numbers behind it. Japan was the strongest of a weak bunch but the whole region is under a dark cloud of uncertainty over China’s short term economic outlook.

The first shocks have hit the market and there will undoubtedly be more aftershocks. One of the longer lasting aftershocks will be in the energy sector. As governments around the world (like Germany) take a close look at their nuclear power programs, the demand for oil is likely to rise. With the popular uprisings in Northern Africa and the Middle East threatening to disrupt the supply side, oil prices are likely to remain firm for the foreseeable future.

SLV has had a nice run since breaking north of $30 in the middle of February. That is not news but a checkable fact. For those investors who noticed that SLV was at the top of their rankings since July 12th of last year (when SLV closed at $17.62), it was a good opportunity to make money in a relatively non-correlated asset class. The only time it got sticky was at the beginning of this year when the price corrected.

The reason that we bring this up is not to brag. While SLV has done well, other investments that have made it into the top rankings have fared less well. The point is that most of those investments were eventually replaced by new market movers while SLV has hung in at the top of the lists despite the 10% correction that we saw in January. While we may have worried in these posts that the rerating between Gold and Silver may have run most of its course, the System kept pointing out that there was strong momentum behind the asset and that there were not that many more promising assets out there at the weekly measurement points.

My only slight regret…not swapping GLD for SLV a few weeks back when I was adjusting my Seeking Alpha ETF Portfolio. I would have looked very clever. But, in calmer moments, I realize that the regret and the emotion behind that regret is precisely why one should use an unemotional system to help execute one’s investment plan.

So, should you buy SLV now? Well, that all depends. Does it make sense as part of your universe? And, if it does, ask why? Make sure that you are not adding at this point because of past performance. Make sure that it is in there because you think other investors are worried about the US dollar or you think there is a chance that the Biomedical uses of silver are poised to go through the roof. In short, remember to separate the Asset Selection process from the Asset Trading process. And what happens when something better comes along in your universe? That’s easy, switch.

A Tarnished Example

Now that PIMCO has finally gotten it through to folks that, yes, they really are not keen on US Government paper (no link…too many choices), let’s look at how two bellwethers fared in the Fund King System.

TLT (which tracks 20 year plus US Treasuries) has been at or near the bottom of the US Sector ETF Universe since the beginning of November 2010. And less long term TLH (tracking 10-20 year Treasuries) has joined the bottom of the pile in another ETF portfolio since the end of November.

So, whether you were in the “Don’t Fight the Fed” or “Hyperinflation Around the Corner” camp, the Fund King System told you to steer clear of the asset class for the last three months. Even the FED could not buy up enough long dated Treasuries to keep TLT from dropping 10% over the period. Mr. Gross, the head of PIMCO noted in his newsletter that the FED has been buying as much as 70% of the newly issued Treasuries of late.

What does it mean?

There is nothing wrong with SLV , TLT or TLH in absolute terms. Each of these ETFs represents claims on perfectly good assets. The deep meaning to take away from these two examples is that it does not pay to fight the trends. If investors (on balance) are shifting money out of US Treasuries and into hard assets like Silver, there is little point in trying to stand in the way. At some point, the tides of money will change directions and other asset classes will get swept up or down. When interest rates rise a couple hundred basis points, Bill Gross and his PIMCO colleagues will be back on the bid side. Why? Because they are in the business to make money; and money is made by buying low and selling high.

An interesting read

Supporters of Ron Paul can sometimes be a prickly bunch. But, they occasionally come up with very thought provoking concepts.

I like a good bash so when I came across an article entitled: “How to End the Federal Reserve System” by Gary North, I was prepared for a rehash of the old arguments about an evil cabal on Jekyll Island in 1910. But the real strength of the article comes about halfway through when Mr. North analyzes the demise of a government agency which had also been granted monopoly powers: the US Postal Service. He draws some interesting parallels about what technology could do to the Federal Reserve System long before Ron Paul and his supporters in Congress are able to rescind the Fed’s legal mandate.

Basically, the ability to move into other currencies with a few well place computer key strokes or even to develop new mediums of exchange means that even an institution as powerful and influential as the Federal Reserve is not immune from obsolescence.

Part of the appeal of ETFs like GLD and SLV is that they are theoretically redeemable into a fixed amount of Gold and Silver respectively. While pitched as a new idea, the concept of convertibility into precious metals was once the cornerstone of the US dollar’s value (and most other currencies before that). In an interconnected world that can work with services like PayPal, it’s probably only a matter of time before someone reinvents a multinational global fractional banking and payment system backed by gold, silver or some other store of value. If it is tied into Visa, Mastercard and American Express, one need not worry about carrying about sacks of heavy metal to the grocery store. Just as email eclipsed the first class letter (something that was unthinkable as recently as 20 years ago), there is a risk of a new currency system taking the premier spot occupied by the US dollar today.

Just because the risk exists, however, does not mean it will come to pass. The biggest difference between the US Post Office and the Federal Reserve is that the latter is a privately owned, profit seeking entity. Long before we are all paid in PayPal credits or Googles, the Federal Reserve (which is owned by and represents the largest US banks) will feel compelled to take steps to shore up the value of the US dollar. That more than anything else will lead to a change in policy that will likely see higher interest rates in the not too distant future.

While you are pondering your long term investment strategy, make sure to include a plan for higher interest rates.

What happens to Japan now?

The earthquake and tsunami that hit Japan on Friday will impact the country and the economy in ways that are hard to foresee at the moment. Despite the shocking video and photos, however, the natural disasters are unlikely to have a significant long term impact on the economy. As long as the authorities can keep the nuclear fallout to a minimum, the biggest issue will be reconstruction and who will buy the fresh batch of JGBs. That points to another force for higher than near zero interest rates in the world’s #3 economy.

From an investors’ point of view, the Nikkei 225 was the best of a weak bunch (Asia has lagged since November of last year) in our universe of 11 Asian indices as of Friday’s rankings. The earthquake and tsunami do not significantly change the long term public finance fundamentals of the country and most of the familiar exporting names have transferred significant portions of their manufacturing base to locations around the world in the last few decades.

Should you buy? If your universe is only Asian Equities: then perhaps. But, if you are looking at a broader range of asset classes, there are quite a few commodity based ones that look more attractive. As Japan is import dependent for almost all of its commodity needs, there are better places to invest your money.