Archive for January, 2011

Those That Fail To Learn From History

Weighing in at 545 pages, the Financial Crisis Inquiry Commission has finally come out with a report that “didn’t produce new culprits or scandals” according to the Wall Street Journal report. It looks like the Commission has succeeded in its primary task…to bury any useful institutional lessons in a pile of paper.

The first paragraph of the article however, should give one pause:

Twelve of the 13 largest U.S. financial institutions “were at risk of failure” at the depth of the 2008 financial crisis, while at least 50 hedge funds tried to capitalize on it, according to a report released Thursday by a U.S. panel investigating how the financial system unraveled.

…are doomed to repeat it.

Whether you prefer the George Santayana or the Winston Churchill version of the famous dictum about the risk of ignoring the lessons of history, the lack of serious introspection on the Global Financial Crisis means the seeds of the next bubble are being sown right now. The must obvious suspect today would be sovereign debt but one shouldn’t concentrate all one’s attentions on the US and EU. S&P’s downgrade of long term Japanese debt (AA to AA-) may be the first signal of the next bubble getting ready to pop. With extremely low interest rates (ie. high bond prices) and a debt to GDP well into the triple digits, it would not take much of an interest rate rise to cause serious fiscal problems in aging Japan.

Wealth vs. Money

The most interesting thing about investment professionals is how few of them actually know the difference between money and wealth. If one wants to be generous, one can put that down to being so close to the tree trunks that one often fails to perceive the forest all around (after all, the tech fund manager is paid to watch tech stocks, not worry about oil prices). The problem for investors is that a broader perspective is crucial to constructing a wealth building program that will deliver the resources in the long run to meet one’s long term financial obligations.

When we started the Fund King blog, I thought of writing a very deep piece about what money really was and how that related to wealth. When investing, money is obviously an important tool but the actual long term goal is to build wealth. That is why we have structured the Fund King Website not as a “Hot Tip Sheet” but rather as a System for achieving solid long term positive investment returns. The System is important; the actual investment vehicles are just a means to an end. It is a top down look or, if you want to stick with the imagery in the previous paragraph, we are more concerned with the shape and size of the forest than any particularly attractive (or ugly) looking tree.

Although I never got around to my piece on the nature of money, I was reminded of the relationship between money and wealth by a video series from a leading Internet Marketing guru named Eben Page. Although he starts from very basic first principles, his handle on the subject is very close to my own, which either means we are both very right or very wrong. Now, a word of caution: these videos are part of a massive Internet Marketing pitch. The standard format is to offer some solid free content to entice you into plunking down serious four and sometimes five figure fees for a more extensive training course. I think the free videos are enough to get one started but if you want to go whole hog…Caveat Emptor and I have no financial interest either way.

What is Money?

Simply stated, money is a medium of exchange. Up until the last century, money was usually associated with a rare commodity that was easy to carry (although certain Polynesian Islands were known to put great store into large rocks that were too big to move). The key was to have something that all market participants could accept as a store value and be useful to grease the wheels of commerce. Since people worked for money, that has led some economists to define money as a call on future labor. This concept makes sense when you think about the actual components of value added in any service or product. Even something as commoditized as a barrel of oil would never make it to the refinery or your fuel tank without a massive element of labor to find it, bring it to the surface and transport it to the refinery. Some of that labor is now encapsulated in capital goods like oil derricks and supertankers but even those came into existence only as a result of the application of healthy doses of labor (as well as capital and materials but you can see how it all gets very circular). How does that work for most people in modern society? Well, when one is young and enthusiastic, one trades labor for money. As one becomes more proficient and productive, the amount of money for a given unit of time increases and most people manage to accumulate a bit of a surplus. After one retires, one can run down that surplus to buy labor from others (at grocery stores, restaurants, hospitals…). The picture is complicated by Government transfer payments like Social Security but for simplicity’s sake, we will stick with the standard and simplified “life cycle” view.

As soon as trade regularly occurred with counterparties “over the horizon” rather than in face to face transactions, money needed to become more mobile. Paper money redeemable in metals, letters of credit and loans were the innovations that helped drive the Renaissance and create the wealth that helped Europe dominate world affairs for 500 years.

As our economy has evolved, globalized and entered cyberspace, the actual nature of money has kept pace. While members of the Austrian School of Economics (of which I am generally a fan) will rail against the evils of fiat money (which is often characterized as “paper money”), a quick look at the M1 vs. M3 figures at Shadowstats.com will show you that less than 15% of US dollar money supply is actually composed of what most of us think about as money. The rest is 0’s and 1’s which are stored on computers and zipped around the world at the speed of light.

In fact, the way money is created in normal economic times is actually not by the government but by private banks engaging in fractional reserve banking which involves holding a fraction of depositors’ funds in the vault and hoping that everyone doesn’t show up on the same day to withdraw their money. When Christmas rolls around again, pay close attention to the Savings and Loan scene in “It’s a Wonderful Life”. The only difference between then and now is that the US Government has spread the risk evenly to all existing and future taxpayers while bankers rarely feel the need to head for a bridge when things turn sour.

Although money is a store of value, it is not a cost free. Even in the absence of inflation, the value of a dollar today is higher than that of a dollar tomorrow. This is called the time value of money and a whole structure of interest rates are available to put hard values on how much must be received to avoid the deterioration of a dollar into the future. Ask anyone who has run up a substantial credit card balance about the cost of spending money today (I only had to do it once to learn my lesson). Add in inflation, and the value of a future dollar is almost guaranteed to be significantly less than the value of that same dollar today. But what about deflation? While deflation would be the reverse and make future dollars more valuable, the political ramifications are too unpleasant to contemplate. The only real deflation that we have experienced over the last few decades has been that of computing power. How often have you bought a computer or flat screen TV only to see the same or improved model on sale for less in a few short months? Now, imagine a whole economy like that and you can start to understand why the Japanese are such reluctant consumers and have seen their economy stuck in neutral for two decades. When Ben Bernanke says it won’t happen in the US, you can believe that he will do his utmost to deliver on that promise.

What is Wealth?

Wealth is an asset that produces income in the future. That income may be hard to perceive today which is what gets both growth and value investors out of bed in the morning. The asset can be a hard asset like a factory or a piece of real estate or it can be more ephemeral like software or a business process like McDonald’s. Taking it one step further, an income producing asset is almost always a system for creating value. Whether that is a business process or an investment process, the key is to find a vehicle for creating value on a sustainable basis. That vehicle is what constitutes wealth. If it is valuable enough, we can use it to create the money income we need or we can sell the asset itself when we need to.

When you look at lists of wealthy people, they do not say that Bill Gates or Warren Buffett or the Sultan of Brunei actually has so many billions of dollar bills or gold bars stacked up in a vault somewhere. These billionaires (and the estimated 20m millionaires beneath them) have estimated their wealth in money terms for the purpose of calculating a number. In fact, if Bill Gates were able to dump all of his Microsoft on the market in a hurry, one would expect that he would have to take a significant haircut. The fact is that while we measure wealth in terms of money, real wealth is rarely kept in what we would view as actual monetary instruments.

The purpose of investing is to trade money for assets that can, at a later date, be converted back into money when we need it.

In the financial asset world, there are any number of assets on the shelf which one can buy. The problem is selecting the assets that will help you reach your investment goals. Some assets will be too illiquid. Some will be too volatile and some will just plain stink. Although some investment gurus have proposed that there are no bad assets just bad prices, there is enough fraud and stupidity in the market to justify the claim that some investment opportunities are actually just bad.

So what should an investor do?

The first thing one should do is recognize the difference between money and wealth. Money is a critical factor in acquiring wealth and one can certainly measure wealth in monetary terms but they are not the same thing. Holding money imposes an opportunity cost on our overall portfolio, particularly at the low interest rates that prevail throughout most of the developed economies.

Therefore, we think one should develop a system to turn money into productive assets on a systematic basis. The first part of that puzzle is usually but not always a systematic savings discipline. But once one has accumulated money as capital and one is ready to turn it into productive assets, one needs a systematic plan to make, manage and monitor the assets. Obviously, we think the Fund King System is a good way to approach this conversion and management process but it is not the only system out there.

As an investor, it is critical to take control of your investment process from the capital accumulation through to the capital deployment and measurement processes. If managed correctly, the result should be a level of wealth that will help you meet your financial obligations and perhaps have a bit left over for your family, charities and other good causes.

Is China more expensive than Boston?

eggs Is China more expensive than Boston?An informal study picked up in this Wall Street Journal blog shows that a number of basic items in East China (Hangzhou, Zhejiang Province) are actually more expensive than the same items found in Boston. The study compares basic things like eggs, milk, beef, gasoline and apartments and finds that those aspiring to join the Chinese middle class are going to pay heavily for the privilege.

When I was an expatriate in Shanghai in the 90′s, the cost of living for my family was 50% higher than that of Hong Kong but that was largely due to government imposed restrictions. Private housing was a brand new concept, expats were restricted to certain government controlled areas that charged outrageous rents and private car car ownership was almost unheard of (bicycles and buses were the main form of transportation around town). Beef and milk were frivolous luxuries and priced accordingly. A comparison of this sort 10-12 years ago would have been an apples-to-oranges type of undertaking.

But in the major cities of Eastern China (Zhejiang Province, Jiangsu Province and Shanghai municipality), owning a 100m (3600 sq ft) apartment, driving a nice car and buying more than rice and veggies for dinner have become the signposts of entry into the middle class for the young urban professional couple and their one child. The fact that these prices are both on the rise and that they constitute a much higher proportion of disposable income than in Boston is a serious political issue for China.

But Chinese officialdom is no better off than the hamster on its exercise wheel. Slowing the economy to control inflation imported from the US FED’s extremely accomodative policy (through a nearly fixed exchange rate) runs the risk of stalling the economy and sending tens of millions of urban workers to the unemployment lines. Keeping the hamster wheel going at present speed threatens a return to double digit inflation off a not so low base (as demonstrated in this article) which will eventually price China out of its traditional export based markets.

Mexico geared to US Growth

Although most of the news out of Mexico revolves around the brutal drug war, EWW, the Mexican ETF has been performing well and has creeped into the top rankings. As we noted in our December 13th note, the Mexican market is dominated by American Movil (AMX) which makes up 24% of the EWW ETF’s holdings. Right now that is a plus but it means that the Mexico ETF is not as diversified as most.

For another, expert opinion on Mexico as an investment target, check out this article written by Frank Holmes of US Global Investors, based in San Antonio, Texas.

EWW ticks several boxes for us. First, it is a developing market which shares a massive land border with the largest consumer market in the world (where 80% of exports go). It has cheaper labor costs than the US which could sway investment decisions as corporations rebuild capacity in the coming years. And, like other successful emerging markets, it is moving up the value chain in terms of production. As the US slowly climbs out of the Financial Crisis hole, Mexico looks like a geared play.

January Effect

As we cross the midway mark on January, the various portfolios that we run under the Fund King System are all pointing in the same general direction. Commodities (metals, softs and energy), and US sectors – tech, regional banks (acquisition targets) and small caps are all clustering around the top of the rankings.

Part of the reason is the stimulus package which came attached as a condition of continuing the Bush tax cuts beyond their expiration date. According to this article in Zerohedge, the payroll tax cut and the “Make Work Pay” tax credit will amount to 180 billion in stimulus this year. Add in the main premise of the article, that non-paying mortgages amount to a stealth stimulus, and much of this year’s expected GDP growth is coming from non-renewable sources. What is not stressed in the article is that the $1.4 trillion dollars in non-paying but not yet foreclosed mortgages amounts to 10% of US GDP. Some of that money will be recovered eventually when the foreclosed houses are sold but it is safe to say that in the meantime a big chunk of wealth is tied up in the process.

But if the US were the only economy to consider, commodities would be heading down rather than up. Commodities are rising because developing countries are importing the incredibly loose monetary policy of the US through linked exchange rates (or simply a desire to stay export competitive). Whether one thinks China is growing at 7% or 10% (and there is a range of opinion even within China’s government), a near zero percent accommodative monetary regime is not the correct policy response. A number of articles comparing today’s situation with the Asian Crisis of 1997-98 have started to connect the dots which is why there are so many warnings of overheating in China (ie. we have all seen this movie before and we know how it ends). The flooding in Australia may add further pressure to the inflation picture. Coking coal is a key ingredient in steel production and the flooding in Queensland has temporarily suspended production at mines which amounts to an estimated 40% of world supply.

Which of these trends has staying power? Small caps are famous for running out of steam as soon as February rolls around. Regional bank acquisitions might trundle on for longer because the industry is due for consolidation and the banks at the top of the feeding chain are not only TBTF (too big to fail) but enjoy preferred access to Central Bank funding. The jury is out on the tech surge. If cashed up corporations are ready to invest in productivity enhancements, there might be a sustainable trend. If the improvements are just part of the inventory restocking, then the sector will fall back next quarter. Only the upward pressure on commodity prices appears to have staying power for now. So, watch the System closely because we are likely to see leadership changes in the coming two or three months.

Seeking Alpha Portfolio

SAweek09 January EffectThis week is a good time to review what we have in the 20 ETF Universe and start to plan for any changes we might want to make at the three month mark which is coming up in three weeks.

The changes will center around correcting for my bias in favor of Emerging Markets and Asia, potentially removing SPY because it is too broadly based and adding at least one fixed income asset class.

A quick review of the performance of the portfolio: We are currently holding 250 shares of IXC (Global Energy), 550 shares of EWT (Taiwan MSCI), and 160 shares of EWW (Mexico Investible) plus $659.85 in cash. So far we have racked up $87.45 in commissions and $1,450.50 in short term capital losses. The portfolio was up 2.1% last week so we are still underwater in week 9 with a total loss of 1.86%. We started with $30k on November 15th and at Friday’s close, we are looking at $29,441.95.

As you can see from the ranking, there is no need for any switches this week.

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