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Emerging Market Hedge

This morning I'm reporting on Thai economic growth over at TheStreet.com, and how amazingly, in the global liquidity crunch, it's managed to trend upwards -- and fairly fast, too:

In August, year-over-year exports in Thailand rose 17.9% vs. a rise of 5.9% in July, while the country's trade surplus rose to $770 million from $211 million. And at the end of September, the Ministry of Finance revised economic growth for the year up 50 basis points to 4.5%, and at 31.64 vs. the dollar, the baht is climbing its way back up to its July levels.

The scenario is a far cry from 1997, when the baht dropped 30% overnight vs. the dollar and Thailand was thrown into a cash crisis.

Now, contrast this scenario with the U.S. economic outlook:

As of Friday, Thomson Financial pegged overall third-quarter earnings growth for the S&P 500 at an anemic 1.4% rate. Should that come to pass, it would be the worst performance since the second quarter of 2002, when earnings rose by the same amount.

Analysts note that a weaker U.S. dollar, which continually set record lows against the euro during the third quarter, undoubtedly aided some export-heavy sectors. Unfortunately, the belief is that housing woes and a slowdown to the U.S. economy will sabotage profit growth for many.

"Downward estimate revisions have already come in from the banking sector, consumer finance, and mortgage companies," notes John Butters, research analyst with Thomson Financial.

And -- most fascinating -- on a rate cut conspiracy theory in Thailand:

The argument goes that consumer price inflation was down on the year to 1.1% in August from 1.7% in July, creating the right conditions for a rate cut alongside relative weakness in Thai securities, which have yet to feel the effects of positive economic growth in the country.

The rate cut would most positively impact home builders and financial stocks, giving what many say is a long-overdue boost to the Thai stock exchange (SET) in general. In the last year, the SET has advanced 37% to 847.93, much less than other regional stock exchanges: in the same period, the Hang Seng has gained 65% to 27,066, the Korean Kopsi is up 54% to 2003.60 and the Shanghai Composite Index has soared 217% to 5552.3

It's going to be an interesting week. I have a feeling that you'll see the SET take off amid all the positive spin on the Thai economy after the BoT meets on Wednesday -- even if it doesn't cut rates (great time to get some exotic SET index futures right now). Wednesday also happens to be the day the official transcripts of the Fed Reserve meting last week is out, which is not going to be as pretty, unfortunately. After last week's uptrend in the Dow, expect some mild nausea from the prop desks in NY. This could be a good time to purchase some put options on the Dow, alongside those SET index futures, and create almost a mirror-image opposite hedge of the one many were playing with back in July 1997.

It's a good emerging market hedge for the following reasons: it concerns two rate-slashing, tame  inflation markets (unlike, say, China or Brazil), one is an export-led economy and the other is an import-led economy, and it takes advantage of all the emerging market growth around. Let's see if you would have been in the green on Friday.

Chasing Beta: Bernanke & Greenspan

Here is a very well-written article about the current US market scenario. Despite my recent bullishness, I have to concede that the Fed's 50 b.p. cut in interest rates was sheer lunacy. The only defense I can think of to support such a cut is that it is just so completely mad that it might actually work. As several commentators have pointed out already, the Fed now has nowhere to go if the going gets tough again. While it's still too early to tell whether this will be the case, it is impossible not to agree with the logic behind Peter Bookvar's (Miller Tabak) statement :

'You don't have a multi-year credit bubble that is over in a couple of months; why the market thinks that is beyond me.'

It's also interesting to see everyone hammering Greenspan right now for having kept rates so low for so long in the 1990's -- as if he is personally responsible for the current volatility. If Greenspan was foolish, then Ben Bernanke looks like a circus jester: giving markets not only a multi-billion cash-fuel throughout the summer, but then topping it all off with a giant, unprecedented rate cut. This is not to criticize Bernanke per se; in many cases he has helped stimulate markets out of a recession which could have been especially difficult to shake off. However, the fact remains, there is always a cost where there is a benefit, and when you stimulate an economy so quickly out of a recession, you get lot of hasty money.

On a further note, it will be interesting to see the consequences if the market does hold up. As I pointed out recently, one potential effect is that speculators increasingly look overseas to the heady emerging markets for record gains:

This recent action in South Asia's derivatives markets looks interesting alongside the ruminations of the supposed global credit crunch. For if there really is a shortage of global liquidity, then why are funds buying ultra high-risk emerging market equity derivatives?

... What appears to be the case is that given the European and U.S. authorities' enormous cash fuels to domestic banks, these banks and funds have started to look for the same kind of gains they were getting from speculating on sub-prime. After all, there is still demand from the hundreds of event-driven funds out there. An obvious contender is emerging market derivatives, which are volatile, but extremely high return. And with emerging market growth soaring this year, the equities possibly look like a good bet.

This would give us almost a mirror-image picture of the 1990's again -- where funds couldn't resist over buying emerging market securities and in turn over-stimulating their currencies, until the whole global system temporarily collapsed. In that instance, it will be much easier to draw parallels between Bernanke and Greenspan than critics of the former chairman of the Federal Reserve may like to admit.

Macro/Micro

Contrary to my comments the other day, it seems that if you have been reading this blog since the beginning of the year, you'd actually have made some decent money (LINK):

And for what it's worth, here's what happens next. The current US economic and market strength will continue at a bullish pace right up until about September/October, when a spew of economic data will show how in Q2 we got just a little ahead ourselves. This, combined with some instability created by a looming election, will prompt some of the big pension funds to throw money back into gold, and it will have a natural, short-term correcting effect for markets (which in all probability probably won't be needed so it's a time to buy then). However, because of this overreaction, we'll probably see that growth re-bound in the final quarter of the year as Q3 fundamentals show everyone that things are actually still in pretty good shape.

And while the Japanese may raise rates, as might China, don't expect too much discipline from the governments of these economies. When Asia has a run, she's usually more afraid of stopping that run too quickly than she is of letting it overheat, so though she might put in a quarter-percent rate hike here or there for show, it's not in keeping with the general ethos of the region, which tends to get a little overexcited about its own economic prospects (usually as a result of knock-on growth from the European region and the U.S.A.) In other words, right now, you want to be buying Japan.

The Nikkei shot up to over 18,000 after that comment was made. Japanese equities look good again right now, with the Nikkei up more than 10% on the month to 16,845.96, and the yen seems to have regained regional stability. And - surprise, surprise - the Dow is back to an all-time high (I said that HERE recently too).

One of the side-effects of globalization is that everyone seems to use Macro- data to judge what are, in effect, Micro- situations, like market movements. It's an information overload problem, and it's not always an accurate way of trying to gauge where stocks are headed.

Truly Diversified?

Farnoosh Torabi this week interviewed TheStreet.com's metals writer Simon Constable about the issue of whether Greenspan is to blame for the sub-prime debacle (by keeping interest rates so low for so long). Constable's answers make for poignant consideration (VIDEO HERE):

There's two things here: first of all, everyone in this episode is seemingly saying, "not me, not this, this isn't my fault, it was the other guy, it was my predecessor, it was my mother, it was my mother-in-law ... but it wasn't me." That seems to be what's happening all over the market and it goes all the way back to Enron. It's been a decade of people blaming each other. However, I talked with some economists this morning and what they're telling me is that it was probably a policy decision on his part to say that it was OK, because even though there were going to be some abuses, we'll keep the economy rolling.

Indeed, this seems to sum up neatly the attitude towards economic fundamentals over the preceding 20 years. There are two economic conditions that have made markets amenable to the sort of volatility we experience these days. The first is the focus on growth, above all else, including but not limited to fundamentals, accounting, and even value. It's for this reason the private equity market has burgeoned so much: a singular focus on driving growth as quickly as possible -- with the least amount of hassle.

Added to this, the mass democratization of capital markets, to include numerous retail speculators who now have access to unprecedented levels of margin and credit stimulates this growth like steroids in a professional athlete.

The new economic climate challenges the meaning of the "diversified portfolio." A lot of financial institutions and market commentators like to promote the concept of such diversified portfolios as a safe way to access economic growth, but in reality when the above two conditions are in full swing, diversification becomes much harder to achieve, to the extent that whatever you're invested in - be it commodities, securities, bonds or real estate - is unavoidably at some level a leveraged bet on  the growth of more speculation.   

Things Are Not What They Seem

How wrong we get it sometimes. Not so long ago, right here at The Global Perspective, I shouted off about how crude was destined for free-fall, about how U.S. markets were a straight buy and how China was a short opportunity just begging to be cashed in on.

With crude at $80 for the first time in history, U.S. markets in relative free-fall in the midst of a giant housing credit crunch, and China's markets and economy surging upwards with an unstoppable velocity, the latter scenario doesn't look so convincing -- to say the least. If I was running money I would have been laid off months ago.

Then again, I have the luxury of not running money -- and not having to make gut decisions on a day-to-day basis based on what everyone else is doing. And best of all, for me at least -- but for others who don't yet know it -- whatever the current market scenario, the fact remains, I'm right. There's more oil in the world than suppliers want you to believe, U.S. corporate fundamentals are actually in pretty good shape, and China's companies are still largely run like Taipan-geared hothouses.

In times of volatility, the first thing people tend to forget are the facts. Before you shoot off a vitriolic e-mail telling me how wrong I've got it, let me throw out here some recent examples to illustrate the point. First of all, for all we keep hearing about the shortage of oil in the world, we seem to see very few actual examples of that shortage. In fact, I can't think of one since the 1970's. Oil may be getting a little pricier on average, but it's not like anyone has been forced to stay at home or walk to the nearest mall recently. It's worth remembering that the two people sounding off about how oil is running dry are the futures and options liquid commodity speculators, and those actually involved in supplying the stuff. In reality, there seems to be so much going around that Venezuela can afford to strike bargain basement deals with the City of London. In a time of a genuine oil shortage, this would not be the case: for a start, the U.S. would be deal-making with the charismatic Venezuelan leader.  (You better believe that if London and Caracas will do a deal together, so would New York and Caracas, given the right demand scenario.)

Secondly, U.S. markets are still way up, on average. Right now, you can't pick up a copy of a newspaper without reading a story about the effects of the U.S. sub-prime chaos on equities, but in reality the two have very little to do with one another fundamentally. The reason U.S. equities plunged as credit spreads tightened is simply that in such a market, holders of credit derivatives and equities alike -- and there are many -- couldn't get rid of their mortgage backs, so logically enough, they sold their equity positions. This only had the net effect of turning up a few bargains in the market. Talk of a U.S. recession is premature, too: by definition, those who have sub-prime loans are hardly major spenders in an economy, and therefore, less significant than say, ordinary mortgage holders. The effects of sub prime defaults have been sad to see on a human level -- which is largely why they are all over the papers -- but hardly very significant on a global economic one.

And where China is concerned, the warning sign came for me the other day. "Chinese stocks are a great hedge against global equities, because while global equities have been going down, stocks in Shanghai have been soaring," I overheard someone say the other day. When people start talking of hierarchal Asian growth-stocks as a hedge against huge, stable, flat, industrial organizations with 50+ years of documented accounting behind them, you generally know you're in a bubble.

Right now you're better off not buying a newspaper, or reading a wire report, for that matter. Because the reality is, most of us have become so wrapped up in a human-interest and political argument, we've temporarily lost our economic marbles. Not for the first time, things are not what they seem.   

Dow Passes 13,000

After a rocky start to the year, the Dow Jones Industrial Average has now passed the 13,000 benchmark:

The last few months have been a somewhat rocky ride for the Nasdaq too, but now the index is hitting something close to a five-year high:

I am reminded of what I said about GDP and the knock-on market effect back in November:

America needs to stop worrying about productivity, and start worrying about what to do with all the productivity when it comes about in the next three or so years, or it may find itself back in an enormous bubble. This is what happened in the late 1990's; productivity materialised, but was fed into productively non-existent assets, which killed the productivity cycle.

Either way, another bull market is coming.

Now, everyone's talking about that bubble. I've heard this from some respectable sources, but personally I don't buy into it: the dynamics of global risk appetite (i.e. extra liquid capital from different areas of the world lying around ready to be mopped up) mean this kind of analysis is premature. Rather, we're at the beginning of something.

China Rate Hikes

After yesterday's cautious comments on China's economy by Premier Wen Jiabao, China is raising rates:

China's central bank said Saturday it will raise interest rates in an effort to rein in the country's red-hot economy, according to published reports.

The People's Bank of China will raise rates 27 basis points, lifting the benchmark one-year lending rate to 6.39% and the one-year deposit rate to 2.79%. The changes will take effect Sunday.

More context here (Reuters):

The yuan has now appreciated about 4.8 percent against the dollar since Beijing revalued it by 2.1 percent and set it free from a dollar peg to float within managed bands in July 2005. It touched a post-revaluation high on Friday.

But many economists say the only way to close off the tap of liquidity at the source is to let the yuan strengthen even more so as to make Chinese exports more expensive.

That would help ease the swelling trade surplus, which hit a near-record $23.76 billion in February, far more than expected.

The central bank, in an effort to keep the yuan stable, buys most of the dollars generated by the surplus, for which it must in turn print yuan, thus flooding the banking system with cash.

Gao Shanwen, chief economist at Everbright Securities in Shanghai, said he thought the interest rate rise would only exacerbate that problem.

"Higher interest rate rises can help slow down investment and domestic consumption. With domestic consumption weakening, more and more goods would have no market at home and have to be exported abroad, which would make the trade surplus even larger," Gao said.

Gao has a point: many skyscrapers, consumer goods etc. are made on the premise that consumption will grow sufficiently over the coming year to fulfill orders and demand in the future. If consumption comes off, then this means exports play an increasingly important role in the growth of China's economy. That means you need a very strong U.S. economy to swallow up the excess consumption which cannot be provided for at home, as well as an increased addition of foreign investment to keep those new skyscrapers full.

The effects a rate hike like this - and future rate hikes - may have on global commodity prices will be interesting to see. I pointed out this week that steel may become a lay casualty (for the above reasons), while also pointing to pending rate hikes in China and India, and the consequences of such (Steel & The Carry Trade: Reflexive Market Duality).

Further notable commentary from Aaron Task today at thestreet.com too over next week's implications (Coming Week: Spotlight On Central Banks):

In the wildcard department, Chinese Premier Wen Jiabao made some eye-opening comments Friday, characterizing his country's growth as "unstable, imbalanced, uncoordinated and unsustainable," Bloomberg reported.

The reaction to Wen's comments was notably muted Friday, which may suggest Asian markets' late-February rout was an isolated event. But similar to the time the premier's Chinese New Year holiday declaration about corruption and fraud spurred those massive losses in Shanghai, investors will have two days to mull Wen's latest comments, as detailed here.

In addition to any postmull reaction to Wen's warnings and the subsequent rate hike by the People's Bank of China Saturday, Monday is also the first day of a two-day BOJ policy meeting. Japan's central bank is largely expected to keep rates unchanged at 0.5%. But any comments about future rate hikes could revive fears of an unwinding of the yen carry trade -- or even actual unwinding of trades made by borrowing yen to finance investments in high-yielding securities around the world.

Summary: Markets in Asia Monday/Tuesday (and knock-on effects on the Dow) will be notable.

China's Premier: Growth "Too High"

China's Premier goes on record today in Beijing about unsustainable growth in the country:

March 16 (Bloomberg) -- China's economic expansion, the source of about a 10th of global growth last year, is unstable and environmentally unsustainable, Premier Wen Jiabao said.       

``China's investment growth is too high, lending growth too fast, liquidity excessive and trade and international payments very imbalanced,'' Wen said at a press conference in Beijing today. Energy efficiency and environmental protection issues haven't been ``properly resolved,'' he said.                

Wen's comments underscore government concern that too many factories are being built in China, worsening pollution and leaving the world's fastest-growing major economy vulnerable to a slowdown in demand. A record $177.5 billion trade surplus has flooded the economy with cash, making it harder for the government to cool investment by reining in bank lending.      

``China has maintained relatively steady and fast growth over the past few years, but this is not a time for complacency,'' Wen told reporters at the National People's Congress meeting. ``The biggest problem in China's economy is that the growth is unstable, imbalanced, uncoordinated and unsustainable.'

This is very big news, and effectively amounts to an admittance that the next growth revisions we will probably see for the country will be around 8 - 9%. While this is still strong, it will have wide-ranging impacts for demand in commodities in particular, to growth in the south east Asian region.

The reaction by Chinese markets however seems small: just a dip of 0.72% in the Shanghai  Composite Index to 2930.48, barely a blink from the Hang Seng, down 0.08% at 18,953.50, and even the heavily leveraged and volatile B-share index in China is off just 1.36% to finish the week at 170.21. There is almost certainly bigger declines headed for Monday/Tuesday, especially if the sub-prime fiasco in the U.S. continues to make waves across the world over revised import trends.

*UPDATE* 12.04 pm Further context at thestreet.com where I'm looking at this situation in more detail (Another Shot Across Asia's Bow):

In Hong Kong, investors were speculating over the potential effects of the debacle surrounding subprime mortgages in the U.S. and revisiting the importance of the yen carry trade -- the borrowing of yen to finance investment in higher-yielding assets elsewhere. The broadest consensus is that the subprime mortgage deterioration, despite constituting less than 10% of America's mortgages, will prompt banks to tighten credit standards. That could undermine U.S. consumer spending and prove a drag on Asian exports.

Chisato Haganuma, a senior Japan strategist for Nomura Bank in Hong Kong, says Asian exports -- a crucial source of income to the region -- will "soften considerably" and that the second-quarter outlook for the region is "gloomy".

Just as appetites for risk were starting to normalize again, fears that the U.S. subprime dilemma may have a further destabilizing impact on exports are prompting renewed concerns about an unwinding of the carry trade.

Steel (& The Carry Trade): Reflexive Market Duality

Over at thestreet.com today, I'm taking a look at the potential impacts of the recent Asian emerging market mayhem on the price of steel, and what this says for the global economy (Steel Could Be the Next Victim):

Steel's bulls and bears do agree that global interest rate hikes are coming. If the price of steel continues to climb, then a large segment of manufacturing becomes more expensive, potentially resulting in higher consumer price inflation as producers seek to pass along the price hikes. But those who see the price of steel as already overvalued also see this as a consequence of overheated emerging-market economies, which are overdue for interest rate hikes.

"Both China and India have not raised interest rates sufficiently to cool their economies, while infrastructure project demand is still germinating," says Darby.

Furthermore, if global rate hikes are afoot, growth of emerging-market economies would slow, pushing the price of steel down as oversupply in these economies materializes.

It's kind of a rate hike Catch-22, with steel caught right in the middle as both a product and casualty of volatility in consumption, and hence global markets. I would say at this stage steel is in the process of going from becoming a tool by which you can gage market reactions to one which is driving certain market reactions, especially in duality with the yen carry trade. The problem is, it's also - just like the carry trade - reacting to market reactions as well, creating a reflexive tension (and this is why you're seeing so much volatility right now, with the Dow swinging wildly below the 12,000 level intraday for the first time since December today).

More on the carry trade later.

Japan is still strong

Remember what I said about the Nikkei being a buying opportunity?

This is one reason why: Japan's Economy Grows at Fastest Pace in Three Years (Bloomberg):

March 12 (Bloomberg) -- Japan's economy expanded 5.5 percent in the fourth quarter, the fastest pace in three years, as surging exports prompted companies to increase spending on factories and machinery.         

Growth in the world's second-largest economy exceeded the government's initial 4.8 percent estimate in the three months ended Dec. 31, the Cabinet Office said today in Tokyo. The result was more than the 5.1 percent median forecast of 23 economists surveyed by Bloomberg News.         

``Japan's economy is solid and will keep expanding, driven by a solid corporate sector,'' said Takuji Aida, chief economist for Japan at Barclays Capital in Tokyo. ``The economy is likely to exceed at least its potential growth rate of 1.8 percent in the first quarter.''

I will get around to expounding the Japanese argument, but suffice it to say for now this is a great zone for foreign investment, principally because it's a great bridge between Chinese and U.S. growth.

It's the economy most of us have been longing for - pretty stable U.S-style fundamentals (especially given that lots of the accounting discrepancies have been ironed out since the early-90's debacle) with immediate access to Asia's boom-bust market sex-appeal.

India's 36 Billionaires & The Billion With Just $36

This has to be the most naive piece of propaganda-masquerading-as-financial-journalism I've seen in a long time:

Beijing, Mar 11: Indians topping Forbes' list of Asian billionaires, replacing the Japanese, have flabbergasted the Chinese, who are regularly reading that India is not shining as reported by the Western media and experts.

"I am surprised that Indians have topped the Forbes' list of Asian billionaires," Chen Yu, a media consultant said.

"I must change my distorted impressions about India," she said.

With 36 of its citizens worth over a billion dollars, India replaced Japan as Asia's top breeding ground for the super-rich, the Forbes 2007 listing of billionaires said this week.

Amongst the top dozen Asian billionaires, there were eight Indians led by steel baron, L N Mittal. Asia added 54 new billionaires in the last one year, 14 of which were from India. In other words, every fourth new Asian billionaire was from India.

Compared to the impressive performance by Indian entrepreneurs, the only mainland Chinese to figure among the top 70 richest amongst Asians was Yan Cheung, the self-made woman entrepreneur of Nine Dragon Paper Co, who is the richest in China.

Unfortunately, the assumptions made herein are all too often made by people lacking understanding in what constitutes a successful economic environment, but it makes a good point about the often forgotten ingredients of capitalism.

It's often assumed that the richer the people in an economy, the more impressive it is. In fact, more often than not, nothing could be further from the truth.

Here is what the message of the article really reads: compared to India, China resembles a hub of stability and economic growth (this alone should sound warning signals to those thinking of investing in India right now too). Because when you have a country with piss-poor infrastructure development, more than 80% of the entire country living below the international poverty line, and weakly power outages, all having the highest number of billionaires in the region says is that compounded to these problems, you have an enormous wealth distribution problem, where a disproportionate amount of capital is concentrated within a very thin slice of your society.

One of the criticisms most of often lobbed at a system of open-markets is the inherent inequality such a system creates, but in reality nothing could be further from the truth. It's the reason economies like the U.S.A. and the U.K. are, for example, stronger and more stable than say, the Chinese or the Indian economies. The fact is, in order to have an efficient market system, with long-term sustainable growth created by constant re-investment and spending, the ideal system is one in which more people have more-or-less the same reasonable level of capital available to them, rather than one where a slice of society owns everything. This is only logical: the more market actors, the broader the spread of investment and spending in an economy.

This article is also a a great example of another often-made mistake by even quite senior market analysts: that you can use the same comparables for emerging markets as you can for developed countries. The reason it's impressive when an economy such as the United States' announces the number of billionaires has increased is that proportionately speaking, there's a pretty good spread of the wealth in the economy already, so the number generally indicates a surge in entrepreneurial activity prompted by aggressive capital markets. In India, where one billion people would be happy with $36, 36 billionaires is quite another story altogether.

By advertising that despite shaky capital markets, inefficient transportation, loose power lines (and that's being generous), 75% of her female population currently completely illiterate, India has the highest number of billionaires in Asia, the country only serves to re-enforce the risks and inefficiency in her economy. That's not to wipe India off the emerging markets watch-list, but it is a red light.

U.S.A. & China

Anyone following the performance of the Asian markets this week can be forgiven for feeling a little uncertain about what's going on right now. On Tuesday, the Shanghai stock exchange tanked nearly 9%, bringing the Dow Jones down 415 points with it and making news across the world, the next day it rebounded 3.9%, Thursday the market slumped again nearly 3% and in today's trading it inched up 1.23% again. Tarrying the performance with other markets in Asia only leaves one more confused: on Wednesday when China was strong, the Hang Seng and the Nikkei continued their spiral in the other direction. Only the past two days have we seen some kind of conformity in Hong Kong and China's market performance, but it's safe to say that by and large results are mixed, and even then, as these markets have finally regained a small footing (the Hang Seng ended the day up 95.41 points yesterday at 19,442.01), Japan fell further today and at the time of writing the Dow is trading down 75 points at 12.159.44.

While all this is a volatility trader's reprise for the several months of straight vertical performance we've had in world markets, it doesn't say much about what's to come for the majority of us.

First of all, while there may seem like a general feeling right now that things are not good for markets, this is a gross over-simplification of what's going on, so I'll explain the general arguments and then then I'll give my take.

In China, the most widely-touted argument going around right now is that while market performance is uncertain and stocks may be overbought, the underlying economic growth of the country is actually pretty strong. In other words, keep buying into China and doing deals there, just stay away from the Shanghai and other regional stock exchanges right now. This has to be the most misleading piece of economic propaganda I've heard come out of the region in a long time. Just relate it to the argument being made about the U.S.A and you'll realize it makes no sense at all.

In America, the argument is that the economic performance of the country is slowing down, and so markets too don't look such an attractive bet right now. The U.S. global goods report released last week, indicating that perhaps we'd all just got a little ahead of ourselves with our positive forecasts, was in part responsible for the big reaction on Tuesday, and this type of data is still having an impact on the shelling spree we are seeing in the Dow, the NASDAQ and the S&P. In fact what we are seeing in the markets now is exactly the type of scenario I predicted we would see in Q3, it just came earlier than expected. This makes sense given the Asia context too, which many forecast as inevitable but "earlier than expected".

The point is, you don't get strong economic growth and slumping markets in an open economy - at least not for long, because such disparities contradict one of the most fundamental principles of macro-economics: that if there's a buying opportunity, someone will see it and snap it up. In other words, if it was possible that you could have a booming domestic economy with weak domestic markets, it wouldn't be for a very long period because it would be an enormous arbitrage opportunity that everyone would see and buy into until markets reflected economic performance, and the situation returned to parity.

So, if China's economy is still booming and America's is falling apart at the heels we should seize this opportunity to buy China and go along with all the bears in the U.S. and sell the Dow, right? Completely wrong, and here the argument gets slighty more complex. Once a market is established in a country as a primary force of capital entry and exit, that economy in which the market operates is to a large degree affected by that market's performance, with little abstractions. Remember the period 1996 - 2000? U.S. markets were surging upwards, and the economy followed. Business was created, companies had more capital to play with, and everyone by and large got richer; if they didn't actually get any richer they at least felt richer (i.e. that an opportunity was 'just around the corner') and they spent more, meaning business got richer again.

What China has done over the past few years is viciously promote its own domestic markets - sometimes to the point where she declared she had no need for U.S. capital since her domestic markets were flush with cash - and as a result, China has come to resemble a typical open market-based economy. Now, what happens to a market-based economy when it's way overbought? You can answer that question by looking at the United States in either 1929 or 1999/2000. The market spirals, and all the processes described above during that period go into reverse.

Here's a practical example. Let's say a year ago someone came to you with a hot new Chinese company idea and said "we're raising $50 million right now, do you want in?" You'd be stupid not to say yes. And what about if the same thing happened today? You'd be more hesitant, and so would everyone else, which means either the capital needed to start the company wouldn't materialize and it would never get off the ground, or that it would take longer to materialize and it would be delayed. Which means either no more jobs created by the new company or jobs created by the new company would come open later. The point is, either situation doesn't encourage faster, and deeper economic growth.

By taking such enormous state-owned companies like the big banks and industrials to market with such a fanfare, China has pegged her economy to the market, and what we are seeing now and about to see is the first example. Her economy is far more led by her local markets than people are willing to let on right now, or even realize. Just because the country is far away and has a billion plus people, it does not mean her economy works differently. A market-based economy is a market-based economy.

Now, in the U.S., we've all forgotten that even a year ago markets were way, way underbought given economic performance, so right now, that doesn't necessarily mean they are overbought. And they're not. The next few weeks will be a fun time for value traders to pick up some cheap deals which were just about looking like they were going to get too expensive quickly. And the economic data isn't that bad. It just says that the U.S. is a huge economy, and it takes time for huge things to grow (i.e. they don't grow at the same pace as they do in the much smaller emerging economies).

This is why my consensus is distinctly for now: buy U.S., sell China. It's not the end for China, but it is a longer term problem than people are making it out to be. And that's a healthy thing, because it shows how far the country has come on in resembling a fully-functioning open market society.    

China crisis: latest

The latest breaking news from China: China could get worse:

A day after shares in China plunged 8.8%, shares on the Shangahi Stock Exchange rebounded, with the index ending the day up 3.9% at 2,881.07.

But investors in Hong Kong say that the worst is still yet to come, and that the outlook for China's market remains overly optimistic. The Hang Seng ended the day down 2.46% at 19,651.51.

"Equities in China are still much more overpriced than people are admitting at the moment," says Sean Darby, head of Asian strategy at Nomura Bank in Hong Kong. "The Chinese pressure cooker is getting hotter. It hasn't tightened rates that much. There's closed capital account money flowing in and contracting liquidity."

The article is hot off the press from last night EST. I should mention that I wrote it.

Consensus: we are seeing the beginning of a south Asian contagion, though Hong Kong and Japanese markets are unlikely to be affected long-term. More context to follow.

China: it was coming

I have to say, I saw China's steep decline coming at the beginning of the year:

Doubts over the sustainability of last year's boom raise the question of whether 2007 is the next 1997, when Thailand's currency devaluation sparked the so-called Asian contagion: bouts of panic-selling in Asian markets that spilled over into other emerging markets and, eventually, developing ones as well.

"What's often forgotten, I think, is that the way we correlate risk in Asia is very high," says Sean Darby, head of Asian strategy at Nomura Holdings in Hong Kong. "We're almost certainly due for a correction this year."

By tomorrow, we'll all have a clearer idea of how far the Chinese market declines are headed: will blog more. Meanwhile, the article helps explain some of the reasons for the decline.

Market Direction & Portfolio Positioning

Sundays are usually pretty quiet, and generally consist of a little preparing of things to do for the coming week, a few coffees at the great Italian coffee shop over the road from my apartment in the East Village where I live in Manhattan while reading the news and some research reports, culminating in four hours or so of Law & Order re-runs on the couch after lunch.

Not so this Sunday. A ton of work awaits me this week - several stories, papers, a video-story (more on this another time) and two overdue chapters of a novel - all of which needed attention, my Dad flew into NY on business, and graciously, thousands of new readers decided to stop by for a casual weekend post I'd written on Saturday about mistakes Europeans make when they're in the U.S.A. In total, there were 73 comments by the end of the day on the post.

I have said here before that hearing from readers is one of the principle reasons I write this blog, and I believe passionately that it's the key concept at the heart of journalism and the arts for that matter too. As my grandfather once told me, "you can have the most talented opera singer on the stage, and the most splendid orchestra behind her, but what are they without an audience? Quite."

So I want to kick this week off by focusing on a comment made on this blog by a reader called Don, as a response to a post I wrote on Friday called "What Does This Mean?" The post concerned the nature of business news, and specifically what kind of business news was useful for investment decision making and what kind was useless, with some general outlines on how to identify the former from the latter to enable clearer - and better - investment choices. Don had this to say in response:

While there are thousands and thousands of opinions on the market in general (and they are best ignored), there are only two behaviors...buying and selling. We seek these so called expert opinions because they provide a level of comfort in an uncertain world, especially if the opinions match the way our portfolio is arranged. Personally, I would rather have my portfiolio set up to match the behavior of market participants. Right now the buyers are in charge, so I stay long. When that changes, so do I.

I find several things particularly interesting about this comment. First of all, it represents the belief and behavior of lots of market participants at the same time as being the very belief and behavior that others abhor, in particular the  so called "experts" who always parrot the same piece of obvious wisdom, "buy cheap, sell high". Secondly, it is a strategy that has in part made some enormous amounts of money, and lost others nearly, or maybe all of their portfolio. In fact, it's the same kind of thinking which has brought down numerous hedge funds, most recently Amaranth and Latitude.

The biggest issue with the strategy is that although it doesn't look like it, it is in fact very high risk, because you are trying to engage in a guessing game without any reference to the fundamental state of the market or assets you are investing in. But still, that doesn't mean you can't make lots of money doing it. It is a perfect illustration of John Maynard Keynes' anecdote of the market being like a beauty contest with the grand prize of £10,000 for the reader who could spot the "prettiest girl". Instead of spending time choosing who one thinks is genuinely the prettiest girl, argued Keynes, the readers would instead be wondering who others think is the "prettiest girl". The problem is, when the market turns against you, it can often be harder than the comment makes clear to see that happening (like oil companies right now). But with lots of people in the market thinking the same way as reader Don, such a mentality becomes impossible to ignore, because it in fact impacts the direction of the market.

I think ultimately a portfolio is best divided between a slice of momentum and a a slice of fundamental; that is, by all means take positions in the current market direction, but also don't be afraid to compliment that with sound bets which look right to you, no matter what the market thinks. Most of the advice and news you read on this blog will be the latter kind, incidentally, because I'm a great contrarian, and I believe in looking the other way for maximum profit. Still, no matter how brilliant your fundamental and technical analysis, like the opera singer who needs an audience, you always need market momentum behind you, or all the greatest analyses in the world won't help. When what you think are great portfolio stocks aren't performing, that means taking a commercial stance at some point too, and recognizing your analysis is sometimes just not in line with what everyone is thinking.

"Timing" is to the market what "location" is to the real estate sector.

Nikkei 30,000?

The other day I made the point here that the Japanese were not likely to raise rates much by much more than a quarter-percent any time soon, since they were long-overdue a bull-run which has just got started, and were probably more concerned about stopping that run in its tracks than letting it oversell itself.

Justin Urquhart-Stewart, Director of Seven Investment Management and writing at the London Stock Exchange, makes a noteworthy observation about the potential rate hike in the Japanese economy:

What I find far more interesting is the expected impact of what such a small rise might have domestically in Japan. In the UK if rates rise we quite rightly fret about the impact on peoples’ borrowing and the increase in mortgage payments, as well as the effect on the vital level of consumer spending.

Not so in Japan. It has been estimated that a 0.25% rate hike could increase household income by 1.1 Trillion Yen (around £233 billion!) which is an approximate increase of 0.4% in household income. This in turn could further support consumer expenditure and consequently provide a timely fillip for the vital but struggling retail side of the economy. How quirky does this seem when compared to our heavily indebted consumer society? In Japan the growing army of actual and would-be pensioners have been saving their hard earned cash and, since the start of the depression in the early nineties, have veered away from the financial maelstroms of the Japanese property and stock markets. So an extra “bip” on the deposit rate can have a marked impact.

From an American or European standpoint, it's strange to imagine a world in which interest rate hikes mean good news for everyone, but when the majority of people are debt-free with cash in the bank, it pays off.

Most notably however, the observation re-enforces my previous point about buying Japanese equity at this level. This is because a rate-hike will make everyone in Japan feel little bit richer, as well as a little more secure about domestic growth prospects, and when we all feel that way, we tend to spend more and take more risks; in investment terms, the latter means we move from cash to equity positions.

Added to the prospect that the Japanese will keep the new 0.5% rate flat for quite some time, and you have a pretty perfect 2-year equity bull-run in place. With the Nikkei 225 at 18,188.42, it's catching up fast with the crucial 20,000 mark - having grown by 22.8% in the last year - but still a long way off from the time in the early 1990's when it topped 40,000, which is exactly where you want a market to be when you're buying aggressively: right in the middle with a competitive but not irresponsible upward growth curve.

In fact, I would say that the Nikkei 225 could well reach 30,000 within the next 12 months. Sound ridiculous? Think how ridiculous the phrase Dow 13,000 sounded only six months ago. In the right economic environment, markets often take off far quicker than anyone expects.

"What Does This Mean?"

Earlier today, I was talking to a good friend of mine who was wondering what do with her portfolio and she complained that she was further non-plussed by all the media coverage of stocks. Reading the financial news, I have a lot of sympathy for anyone with the job of actively managing money for a living or for their personal account, so I'll try and help out a little with what type of news piece to read and what not to read. Take a look at these two articles about exactly the same event - the oil price movement - this morning. One is from Marketwatch, while the other is from AP. The reason I pick out these two news organizations is not absolutely random either: Marketwatch is owned by Dow Jones, and the DJ people tend to work very closely with AP journalists. In a lot of bureaus, they actually share the same office, and in most, they share the same building.

Here are the lead and second paragraphs of both articles:

Marketwatch:
Crude erases 2007 losses as data extends rally
Larger-than-expected supply decline sends futures as high as $61.80 a barrel
NEW YORK (MarketWatch) -- Crude-oil futures extended their rally Friday, pushing the front-month contract into the black for the year, in a continued response to data showing a far bigger-than-expected decline in heating fuel during last week's bitterly cold snap, reducing unusually high stockpiles following a mild winter.
Oil also got a boost after some geopolitical flare-ups: Iran defied United Nations demands that it stop enriching uranium, and traders got jitters amid fresh violence in Nigeria's oil-rich Niger Delta region.

AP:
Oil Trading Slow on U.S. Inventory Drop
Oil trading slow as market reacts to surprising drop in U.S. gasoline, heating oil inventories
Oil trading was slow Friday as the market adjusted to a surprising drop in U.S. gasoline and heating oil inventories.
Light, sweet crude for April delivery nudged just 1 cent higher to $60.96 in light electronic trading on the New York Mercantile Exchange, midafternoon in Singapore.

Just for the record, this is bad business journalism in both cases. I hardly need to point out that one can infer completely different scenarios from these two articles about the movement of the oil price. This type of mistake is usually down to a failure of business journalists being educated in the subject they are writing about; namely, business. Both articles miss completely the main paragraph, too, as a result: what I call the "what does this mean?" graph. If you like, it's the "where should I trade?" explanation part of the article. An article is only as useful as a chart if there is no paragraph telling the reader what the news being reported means, and this is in almost every case the giveaway of the difference between business journalism written by someone who really understands what is going on and someone who doesn't quite get it.

A person who can tell you what something means understands the topic they are writing/speaking about, whereas someone who cannot does not. In the case of both these articles, the "what does this mean?" part of the story is side-stepped by inferring whether this is good or bad news into the headline, which is also a classic mistake (to be fair to the Marketwatch piece, there is a sort-of-meaning in the seventh paragraph, but it doesn't relate to the headline very well). A headline does not tell you what something means - it tells you what's going on. (Incidentally, this is not a comment about Dow Jones and Marketwatch, both of which are usually very reliable, although reading business news from the AP is almost always completely misleading, as I have pointed out before).

Now, the same story by Bloomberg:

Oil Is Little Changed After Rising on Fuel Supply, Iran Threat
By Eduard Gismatullin    
Oil traded little changed in New York after rising to the highest price this year after U.S. fuel inventories plunged and analysts said supplies may be disrupted if Iran is sanctioned again for developing nuclear capabilities.
U.S. stockpiles of distillates, including heating oil and diesel, fell 5 million barrels last week, or 3.8 percent, the biggest drop since September 2005, according to the Energy Department. The U.S. and European nations will meet next week to draft a second sanctions resolution against Iran, the second- largest Organization of Petroleum Exporting Countries producer.

Definitely less sensational, but it summarizes the complexity and ambiguity of what's going on really well, without jumping to a conclusion before all the facts have been laid out. Then, succinctly, follows the "what does this mean?" graph:

``The main risk to the oil price is either a boycott of trade, isolating Iran, or a military attack,'' because either would ``influence the production and supply of oil from Iran to the world market,'' said Thina Saltvedt, an analyst at Nordea Bank AB in Oslo. Distillate inventories ``will influence the price'' until winter ends in the Northern Hemisphere, she said.         

This gives a meaning to the story - the global supply-chain with specific emphasis on Iran - and a time-line, namely, when winter ends in the Northern Hemisphere. Now that's news you can use.

Private To Public In 30 Seconds

John Neshiem has a revealing post up about venture capital:

Today I had tea in a quaint hotel in Carmel with an experienced investment banker from Hong Kong. Educated at a top American university, and quite professional, he was immediately impressive. He was interested in what the differences were between "private equity" and "venture capital".

I labored to explain it to him, but was not getting through.

Then he asked if he could tell me about an idea he had come up with for a startup. After he described it, I knew what to tell him.

He took about five minutes to describe his idea.

A venture capitalist can do it in 30 seconds.

That is the difference between a banker and a VC.

The fact that bankers are already -albeit unconsciously maybe - starting to wed the concepts of venture capital and private equity together says some very interesting things about what's to come in the private equity market.

This story also illustrates quite well the confusion - and the extent to which the confusion runs (up to the level of senior bankers) - over the concept of private equity. I encounter this confusion the whole time. So first, for those similarly baffled by the concepts of private equity and venture capital, venture capital is a means of financing a project while private equity is a type of business model. If I have an idea, and you're willing to give me $5 million for a stake in the company I'm starting up to carry out that idea, that's venture capital, and you become a venture capitalist. Now, there are two principal business models we can adopt in running the new company: either we can plan to list it on a market like the NASDAQ, in which case we're going to be running a public company, or we can plan to keep it private, in which case it's private equity.

Now consider that right now, the fad is in private equity. To be fair, it's easy to see why. You don't have to answer to lots of little shareholders, you don't have to file anything like the number of reports you do if you run a public company, and specifically you don't have to hold lots of meetings and announce what you're doing to the public every time you want to do something big like buy another company. With the tightening of regulations on listed companies over the last five years, the private equity model has become extremely attractive to lots of investors. One very senior PE dealmaker told me the other day that he sees the private equity boom continuing for at least another three to four years.

I don't doubt the mid-term buoyancy of the PE market, but there's a grand misconception right now that the private equity boom is self-sustaining. It's not, and it can't be. The reason is that capital has to find an outlet somewhere along the money-train.

It's worth looking back for a minute. Private equity today is very different from private equity in the days of the dot-com boom, when an investor made a private investment on the expectation of a rapid flotation. Here, the exit strategy was in cashing in your shares once other punters had bid them up several times over in price. Two or there years back the exit strategy was in a trade sale, like for the founders of YouTube, where you cashed in your chips in a share or cash payment (usually a combination of both) by a big company like Google. But today, as this story illustrates, there's no discussion of an exit strategy: private equity is just seen as a good thing to be in per se. That means that the only kind of financial reward you can expect from the business model is a substantial dividend payment. While this may all well and good - after all, it's the traditional method of running a business - the one-off monster sales of private equity companies create expectations of enormous returns by investors in private equity.

This is where the story is so poignant as a prophecy of things to come in the private equity field. The venture capital position immediately assumes a sale at some point. Without a sale of some kind, the type of quick turn-around big-return investments that investment bankers love to juice their balance sheets - and bonuses - are practically unachievable, and there are only so many companies the size of Google who can afford to buy a private start-up for $2 billion. So where's the next step? Obviously, the markets.

So, once the investment bankers who are getting in on all the action now discover that they can't sell all their private equity in the form of a trade sale, they'll be quick to push it onto the market. Some clever salesman will probably even bill it a private equity IPO', which makes no sense but will appeal to market punters nonetheless. The problem is, the true gems will obviously have been snapped up already by the Googles/Blackstones, so what comes to market will be more dubious-looking. If you think this is unlikely, look at Neisheim's comment again on what you have to do to make a successful pitch in the VC market: you have to do it in 30 seconds! How many of us can spot a truly great idea in 30 seconds? Does Warren Buffett look at a company for that amount of time before giving it the yay or nay? That's just about long enough the glance the cover of an annual report, and it's about as effective. Nesheim is right of course about the process, but it's the process itself that's so indicative of things to come.

It's the classic type of situation which creates a boom which quickly materializes into a bubble, with all the classic characteristics of a bubble too: distorting the original intent and business concept of the liquid that's keeping it together.

For What It's Worth

I wonder whether anyone still remembers all the fear surrounding the US economy in the last quarter of 2006? The doomsayers were predicting a never-ending hike in oil and gas prices, prompted by, among other reasons, Venezuela or Iran turning off the taps, political tension in the middle east, increased consumption: you name it, there was a reason. I remember, much to my frustration at the time, when I was trying to write an article with the premise that big declines in the oil price were almost a certainty, and I couldn't find an analyst who would say the oil price was due for a fall. It was at that point I knew the price was coming down: if there's one rule in the market, it is never say never, and when everyone is saying never, go the other way.

The other concern was GDP. I pointed out back then that too that it was in fact a healthy sign for the economy that GDP was down, because when you correlate this figure with private investment, they are pretty much inversely related right before a big bull run, after which they return to parity with one another as dividends and investment pays off in productivity.

The situation today?

Oil is at $58, and falling, the Dow is at 12,786.64 and the Nasdaq is pushing the crucial 2,500 mark by about 13 points. And what about GDP? Well, here's an indication:

LONDON (Dow Jones)--Economic growth in 30 of the world's richest countries stepped up a gear in the fourth quarter of 2006, thanks to buoyant activity in the euro zone, Japan and the U.S.

... The U.S. continued to account for the largest share of OECD (Organization for Economic Cooperation and Development) growth, contributing 1.2 percentage points to the 3.3% annual growth rate.

And for what it's worth, here's what happens next. The current US economic and market strength will continue at a bullish pace right up until about September/October, when a spew of economic data will show how in Q2 we got just a little ahead ourselves. This, combined with some instability created by a looming election, will prompt some of the big pension funds to throw money back into gold, and it will have a natural, short-term correcting effect for markets (which in all probability probably won't be needed so it's a time to buy then). However, because of this overreaction, we'll probably see that growth re-bound in the final quarter of the year as Q3 fundamentals show everyone that things are actually still in pretty good shape.

And while the Japanese may raise rates, as might China, don't expect too much discipline from the governments of these economies. When Asia has a run, she's usually more afraid of stopping that run too quickly than she is of letting it overheat, so though she might put in a quarter-percent rate hike here or there for show, it's not in keeping with the general ethos of the region, which tends to get a little overexcited about its own economic prospects (usually as a result of knock-on growth from the European region and the U.S.A.) In other words, right now, you want to be buying Japan.

Some more news on Hong Kong tomorrow.

Financial Journalists, Hedge Fund Managers, Corporate Jets & The Information Game

One of the most regular e-mails I seem to get from readers of this blog goes something like, "I really enjoy reading your blog, and you write really well. Out of interest, what do you do?"

The praise is flattering, but most of all hearing from your readers is one of the principle reasons I enjoy writing this blog; from software developers to consultants to CEO's to journalists, every one has a unique story to tell and a unique perspective to share regardless of whether they agree with what you have to say or not. Debate is what stimulates the ever-elusive search for the hard truth of economic and political reality, and it's one of the main reasons I write, so I'm flattered to hear from so many who are so curious about what I have to say here.

In order to set the record straight then, I'm a financial journalist; that is, I write about markets, business, the global economy and economic shenanigans the world over. Unlike many in financial journalism, however, I didn't come to the task from a journalistic background, but from a financial one; prior to writing professionally, I worked in corporate finance. "Why on earth," many ask (perhaps fairly) "would you leave finance to join an industry seemingly in perpetual decline, monopolized by lay-offs and low-pay?" Answer one: I love it, and writing/researching is what I've always loved doing. At the end of my tenure in corporate finance, I spent most of my time gravitating towards this end of occupational activity than towards raising capital, which is what I was actually employed to do. Answer two: I'm a born contrarian, and I love risk.

It's in thinking about my own career transformation that I realize a fundamental aspect to the general understanding about the industries I have worked in/work in now is continually misunderstood and misconstrued.

Suffice it to say that the premise of this post then centers around a key idea: that the transferable skill sets and goal sets between financial journalism and money management are large. The argument, in my view, has important consequences - and answers - for the debate which has been rearing it's head over the Maria Bartiromo-Citi-corporate-jet-affair; namely, the ethics of financial journalism.

Managing Information

Perhaps due to the monstrous gap in the lifestyle standards between hedge fund managers and financial journalists, it's not often you hear the parallel between the two professions made, but there are in fact more similarities between the job and goal functions than most realize. Specifically, the two jobs focus on one key theme: managing information. As a hedge fund manager, before you begin to manage any money, you have to get your head around the information that's going to make you any money. Central to that process is the ability to be able to see patters and consequences as a result of those patters where others cannot see them. The same is true of financial journalism: if you want to sell popular and meaningful stories, you have to be able to see patterns and consequences before anyone else sees them. This primary ability is central to distinguishing a hedge fund manager from an analyst at a fund, or a financial journalist from a desk researcher. It requires being as truthful to the information at hand as one can possibly and reasonably be, at the same time as being able to judge that the information is consistent with the thesis you set out to research.

Here's a rather simplistic example, but it illustrates the point I'm making well. Let's say you're a hedge fund manager and you have a feeling that there's going to be a major wave of M&A activity in the oil and gas industry over the next year. As a result, you want to lay some large call (buy) contracts on the smaller oil and gas companies, which you think will benefit from the M&A activity, and some equally big put (sell) contracts on the larger oil and gas firms, which you think will be doing the buying and hence punished by the market (when there's a merger or an acquisition, the company that shells out more than the other is usually punished and the one that gets the shells of cash usually rises; although this is slightly different in the recent case of private equity deals, it stands good for this example where most oil and gas companies are publicly traded).

But before you do that, you have to check out whether your thesis is valid, or you could end up losing a pile of money. So first of all, you look at the chart for crude. You look at everyone else's opinion, and talk to all the experts you can find on the subject. Then you look at the oil companies themselves. What are they doing? Are they merging? What are their earnings like for the past year? For the past five years? What does the market think of oil companies right now (that will mostly be reflected in the P/E and P/B ratios, but also in the volumes of traded equities)? Are there any disparities in the valuations of smaller and the larger oil and gas companies? And how about oil exporters? Are they nationalizing oil? Are they reducing or increasing output? What effect does this have on smaller/larger oil and gas companies? Are they the same effects or different effects? What kind of liquidity do these companies have right now?

Now you're a financial journalist who sees the potential for a story on the same subject: wave of M&A activity sweeping the oil and gas industry. The above questions and processes are exactly the same for the research process of your story. You have a thesis, you have a pile of ( mostly disconnected) information and opinion, and you have to whittle it down into something comprehensible and as true as possible that either directly supports or directly challenges your thesis. It's called managing information, and it's what financial journalists and hedge fund managers alike do all day long.

Conflicts of Interest

When you're selling something, doing favors for people gets you a long way. This is not true when it comes to being right and first, and being right and first are the essential characteristics that define good money management and good financial journalism.

Chris Roush, in a post titled "Bartiromo's Plane Ride Raises Questions", seems to sum up pretty well the recent sentiment over CNBC "money honey" Maria Bartiromo's acceptance of trips of Citi's corporate jets at first-class-commuter prices. "Business journalism," he claims "is getting a bad rap after it was disclosed that CNBC anchor Maria Bartiromo took a plane ride on a Citigroup jet from China back to the United States." He goes on:

Bartiromo, according to a CNBC spokesman, took the flight for "source development" reasons, not for any specific story. But based on her long-standing friendship with the now-fired executive, it's clear that she could have had access to him anytime she wanted.

... What bothers me the most is that CNBC and Bartiromo -- who has also raised ethical questions by disclosing on the air that she owns Citi stock -- act is if nothing was wrong with the plane trip.

The problems should be obvious to them. Yes, business journalists are supposed to interview executives and push to talk to them as much as possible.

But the appearance of accepting something -- whether it's a plane trip halfway around the world or a lunch -- calls into question our integrity and motives with consumers of business news. And we're not supposed to be "friends" with the people we write about.

Somewhere along the line, Bartiromo and CNBC seem to have forgotten these basics.

The point that the general criticism, and Roush's post miss is that a financial journalist, just like a hedge fund manager, who is affected by their "friendship" with a Chief Executive to the point where that friendship influences their professional conduct will not be in a job for very long. If there was a major piece of negative news which came out of Citi, but a hedge fund manager who held a large portion of Citi stock chose to stick with his or her trade, knowing full well the stock may come down 5% plus, that hedge find manager would be called to question by lots of angry investors. If the same thing happened twice, the fund manager would find it hard to get a job again managing anyone's but his or her own - and maybe family's - capital.

The same point is true of Maria Bartiromo in the same situation: if her judgment as a result of her "friendships" with Citi execs were unduly affected in a crisis situation to the point where she was influenced enough to try and 'spin' the story, or worse, not to break the story at all, you can bet that it would most likely cost her her career. Even if she consistently tried to spin positive news for Citi, she, like any market participant, would get found out. It's the old law of "reversion to the mean". In other words, conflicts of interest are difficult not to reconcile in professions where being "right" is the key factor to your success.

Conflicts of interest are not the same in nature for financial journalists and money managers as they are, for, say, CEO's. In the latter situation, where a CEO tries to "front run" the market (make money on expected good or bad news buy buying or selling the stock ahead of time) on a pending news announcement, the action, if not prosecuted, would not necessarily affect the career of the CEO: it would merely make or save him/her a few million dollars. The CEO could potentially continue managing the company without repercussions.

It's perhaps a tough concept to grasp for those used to seeing every conflict of interest as inherently black, but in the case of Maria Bartiromo, the conflict of interest may in fact benefit the public, if only because she becomes more privy to the goings-on of Citi than your average punter, which is at the end of the day, what a financial journalist should be and must be in order to be effective. The same is true of a money manager - the more information they are legally privy to, generally the better for the investors in the fund.

The chastisement of Bartiromo is unfortunately motivated by the same emotion which motivates money managers to denounce the trading practices of successful peers: envy. It's with no uncertain peril we put successful and honest people out of their professions and amateurs in their place because of  overly-simplistic reasoning. Because in that instance, we all end up worse off, less-informed, and ultimately, more susceptible to the exact malpractice we were so afraid of in the first place.

UPDATE: Welcome (back) Instapundit readers! Thanks for dropping in. This is a blog principally about the economy, and you'll find that quite a lot of it is about global as well as U.S. markets. Please feel free to take a look around, comment, and of course, come back any time you like.

GOOGLE hits $500: MSFT hits 2-Year High: NASDAQ at 5-Year High

QUICK NEWS UPDATE (when is the media going to cover all this?):

Just as I predicted, Google stock has broken $500 for the first time today, valuing the search engine giant at over $155 billion:

This is what I said a couple of weeks ago:

Trading at 473.99 at the time of writing, having beaten Wall Street's expectation on Q3 earnings hansomely only a week ago, it's worth putting under the microscope. This is a company which made a 90% jump in Q3 earnings on the year to $733.4 million, and a revenue increase of 70% to $2.69 billion. While that sounds impressive, the company blew $1.65 billion of those dollars on Youtube, and unknown and untested brand only weeks ago. That's another six month's record earnings at the same level to make the acquisition profitable in absolute terms, without dividends, and without re-investment in its own business. And that's if the concept succeeds. NewsCorp bought MySpace on even more tenuous terms less than three months ago.

All this financing action looks very much like a replay of 1995/6, when Netscape and Yahoo! stacked up one-billion dollar plus IPO prices, except that's it happening in the form of trade sales rather than IPO's. That's predicatble enough. The tech bubble of the 1990's may not have endured, but the impression that the internet is a growth and medium catalyst for hundreds of industries didn't lose any lustre.

My guess is, despite Google's precarious revnue model, the stock spikes $500 before the year end, and a few more 'social networking' sites start charging precarious valuations based on their own one year busines models.

Microsoft has hit $30 for the first time in two years today too, making for a two year high:

This benchmarks are extremely significant as a guage of investor appetite for tech. The NASDAQ has hit another five-year high today too. It's only up from here.

New Product Launches

If there's one time you want to buy a stock, it's right before a major product launch. This has been the case for a long time: if you'd bought AOL a week before the launch of any of the Harry Potter movies, or Coca-Cola a week before the launch of Coke Zero, or even Mc Donald's a week before the launch of the chicken burger, you'd be up.

The latest candidate to fulfill this recurring product-launch prophecy has been Sony. The launch of the Playstation 3 has generated nothing short of hysteria, from people charging up to $650 on Craigslist for a place in the queue to get one of the new consoles, to a young democrat Senator's aid using the name of his employer to get some leverage on first-mover advantage on the product. As a result, the company's stock has picked up the best of it over the past couple days.

The following chart shows Sony benchmarked against the NASDAQ over the past six months:

It's pretty safe to call that underperformance. Now look at Sony benchmarked against the same index over the past five days:

In one of the NASDAQ's best weeks since the bull market of the late 90's, Sony stock has practically doubled the performance of the index. Video gaming fans would be best off buying the stock first, then using the gains to get the new Playstation.

11/15: Record Day For Markets

November 15, 2006 may well be remembered as the day U.S. markets turned, although the media are being somewhat sanguine about it. In short, yesterday was a record day for all markets - the Dow, the S&P, the NASDAQ, and for the big new tech stocks like Google.

The Dow broke another all-time high, trading up to 12,326.10 and closing at 12,251.71. That's the first time the Dow has broken the 12,300 mark intra-day and the first time it's closed above 12,250 in the history of the market (the following is a three month chart because it shows the closes better):

The NASDAQ had an equally historic day, reaching a new high since the tech bubble of 2,442.75 and breaking an intra-day of 2,450 for the first time since then:

The S&P however is the really exciting one, since this is the market critics of the recent bull run have been using to justify their bearish views. Only until the S&P starts breaking records, goes the argument, does this rally mean anything (initially it was the same argument used for the NASDAQ until that started breaking records). Yesterday, the S&P broke a six-year high, and was only 8% off an all-time high of 1,530.09 on intra-day trading:

As an addendum, search engine giant Google was 15 cents off reaching the landmark $500 a share that analysts have been speculating about since the summer (yesterday was another all-time for Google too, incidentally):

I expect we will see the stock break $500 before the week's end, just as I said a few weeks ago.

It's getting harder and harder to justify bearish views, and now the talk is all about a bubble, mainly by people who don't understand that a bubble requires the employment of excessive leverage (amongst other things), which there isn't right now.

I have pointed out here many times that a bull rally was only to be expected with lowering commodity prices and a sharp increase in private investment - despite lower GDP, which is feeding that spike in the private investment curve. The equity markets will continue to get the best of it - my predicition is that the NASDAQ tops 3,000 before year's end. And even then it's still cheap.

*UPDATE* Welcome back Instapundit readers! This is a blog about the economy, which is really to say it's about everything from politics to the arts to technology too, because that's really the jist of the economy. There's also a greater analytical scope on markets here than you'll find in most places. As always, please feel free to take a look around, comment and of course, come back.

**UPDATE** The same warm welcome is extended to Ace of Spades HQ readers, Memeorandum readers, and Townhall readers.

In The Bullring

US productivity is down, markets are down for the first time since June 2005 for five straight days (report). Then again, oil is down, sharply, and the Dow is hanging in there above that 12,000 threshold it reached last week and the Federal Reserve is still worried about inflation which means the economy must be growing. Most people are, understandably, walking around with question marks in their heads.

I pointed out a few days ago that productivity was unlikely to be up very much while private investment - which propells broader economic growth and hence inflation - was in the throws of massive expansion, because you don't get material produce - financial or industrial - until that private investment starts paying dividends in terms of earnings and produce. This is why GDP growth was down. Think of it from a personal point of view and it's easier to understand. If you start an online widget business and invest all the savings you have from last year's salary into that business, you don't get paid until either you a) earn something from selling some widgets online, or b) float your online widget company on the stock market and cash in some of your shares. That's productivity and GDP, and it's what's going on this year. It's also a very, very bullish sign for markets, which are all about earnings premiums, not current day scenarios.

To demonstrate this, I plotted some charts. This first one shows all the data from 1970 to present day of US private investment against US GDP growth (both nominal so no one like Daniel Gross over at Slate rehashes the cry me a river debate over nominal vs. real numbers):

There are several points of interest here. First of all, broadly speaking, look how the US has become a much more investment-heavy economy over the years. GDP growth having slowed is only natural, by the way, since it's the old law of 'it takes more to double 1 than to double 100'. The very fact that GDP growth even reaches levels of those thirty years ago says some bold things about the US economy. But most curiously, look how pre-1982 bull market and pre-1995 bull market GDP made a rapid decline as the private investment curve did the opposite and angled even steeper. This illustrates the point I'm making well; GDP declines rapidly if private investment goes up because there's not a lot being actually produced during that time. However, it comes back up a year to three years later, which is about the time all those private companies start paying out stock or dividends and selling some products. But most presciently of all, look how the curve on the private investment line has steepened up dramatically in the last few years. This, accompanied by short-term GDP growth decline, indicates a raging bull market is in the making. It's an EXACT replay of 1995 and 1981.

A scatterplot shows the correlations between the two sets of numbers:

There's a pretty solid negative correlation between GDP growth and private investment. What this means is that it's private investment which is negatively affecting GDP growth, just as discussed above. But what this scatterplot shows most revealingly of all is that this is particularly the case in bull markets, where the scatterplots are huddled together in a downward formation. The huddling effect we are seeing now - low GDP, steepening private investment curve - is the signal of good things to come in the market.

Not converted yet? Let's look at the Dow in terms of historical GDP growth and private investment:

The last two bull markets followed huge declines in GDP growth (the label should say GDP growth but it was late and I got lazy).

This is the Dow against private investment:

... and this one says it all. The Dow, which as I pointed out the other day with charts, leads the NASDAQ, is led by private investment growth: both of the last bull markets followed sharp increases in private investment. The action is actually a little more complicated than that, because private-stage investment and the markets are reflexive - mutually re-inforcing one another - after some time, but neverthless, the piggy bank start to swell first in private enterprise. What is truly alarming is how steep the PI curve has got, especially in correlation with GDP growth decline.

America needs to stop worrying about productivity, and start worrying about what to do with all the productivity when it comes about in the next three or so years, or it may find itself back in an enormous bubble. This is what happened in the late 1990's; productivity materialised, but was fed into productively non-existent assets, which killed the productivity cycle.

Either way, another bull market is coming.

Another AP Blunder: Oil

More terrible business reporting skills from the AP this morning:

Oil Inches Up in Wake of Last Week's Terror Alert in Gulf SINGAPORE (AP) -- Oil prices inched up Monday in the wake of a terror alert in the petroleum-rich Gulf region last week and as traders watched for signs that OPEC nations were following through on announced production cuts.

Light, sweet crude for December rose 7 cents to $60.82 a barrel in Asian electronic trading on the New York Mercantile Exchange.

Now, as you may recall, on Friday the AP's Jeannine Aversa reported that 'markets slumped' after they came off by 0.3% in the morning's trading. Now, it appears, oil prices are 'inching up' in the wake of a new terror alert - despite moving less than the markets did on Friday, by a totally unremarkable 0.1%.

This is not news, it's garbage; leave it alone. The news is that over the past week oil prices have been in a downward freeze as equity prices have broken significant records. But of course, that doesn't sell papers like a terror alert does. Plus, traders have known for weeks about potential production cuts in oil by OPEC - if any of them are reacting to them now they're a little late to say the least. What is interesting to note is the lack of reaction of oil markets, meaning most of that value we saw earlier this year there has now been significantly factored out.

This type of reporting misleads and undermines our economy.

The Mindless Herd

When markets do a u-turn, you always get the few who say the u-turn doesn't mean anything, no matter what the numbers are saying. This is particularly true when someone has a political agenda to push. Daniel Gross at Slate (via Instapundit) is the latest culprit:

For starters, the Dow's success does not mean that stock-market investors in general are thriving, because the Dow does not well represent the whole market ... And because of its weighting system, the performance of a few stocks can have a disproportionate impact ... And serious investors don't even use the Dow as much of a benchmark.

Go and read his piece if you are so inclined; at least it offers some amusement for its sheer financial illiteracy. It's that 'weighting system' argument again, which bears and Democrats alike are all over - despite the fact that, as I said in a recent post, it doesn't really matter at all how the index is weighted when it's buying momentum you're trying to guage and when the total numbers of outstanding shares is much greater than the privately held ones.

This argument is logically flawed too. Re-read this line:

the Dow's success does not mean that stock-market investors in general are thriving, because the Dow does not well represent the whole market

So, when internet stocks were pushing enormous highs only seven years ago under a Democrat government, was it fair to say that it didn't mean investors weren't cashing in because the NASDAQ doesn't represent the whole market (and the NASDAQ back then constituted a much smaller part of the market than the Dow does now)? It's simultaneously impossible for ALL makets - property, commodities, bonds, all equity indices - to be up all at the same time, so no one who understood financial markets would make such a ludicrous claim. Plus, it's wrong. Capital spillage from the Dow has pushed the NASDAQ to a five year high.

On top of that, it's incredulous that Mr. Gross would put his name to a statement like 'serious investors don't use the Dow as much of a benchmark,' especially as he claims in the same post that 'The Dow has a long and distinguished history, and remains the most popular shorthand for the performance of the stock markets.' So - while remaining the most popular shorthand (presumably he means in the financial industry meaning 'serious investors') for the performance of the stock markets, 'serious investors do not use it as much of a benchmark'?

This is herd-talk again, and if anything, the whole self-contradiction should sound warning signals to those who are short right now. Or, dare I say it, banking on a Democrat take-home at mid-terms.

Housing Prices and GDP: A Factual Explanation

An awfully crass and ignorant piece of journalism from Jeannine Aversa, an Economics writer at Associated Press:

WASHINGTON (AP) -- Economic growth slowed to a crawl in the third quarter, advancing at a pace of just 1.6 percent, the worst in more than three years.

The latest snapshot of the economy, released by the Commerce Department on Friday, showed that the slumping housing market figured prominently in the economy's dramatic loss of momentum. Investment in homebuilding was cut by the biggest amount since early 1991.

Then later, after destroying the republican administration for causing this, some experts chime in with real opinions (despite the fact that apparently the Bush administration is seeking to 'downplay' the recent figures):

The Bush administration quickly sought to downplay the slowdown in economic growth.

"Everybody expected this. You have a combination of rising energy prices and also rising interest rates, and now you've seen a reverse on both," said White House press secretary Tony Snow.

Commerce Secretary Carlos Gutierrez said that latest GDP figures displayed the economy's resilience even as the housing market has tanked. "I would not panic about this," he said in an interview with The Associated Press.

Treasury Secretary Henry Paulson struck a similar note. He said the housing boom over the last five years was "clearly unsustainable" and that the housing market "needed to have a correction" by slowing to a more sustainable pace.

Democrats argued that the slowing in overall growth is evidence that the administration and the Republican-controlled Congress aren't doing a good job handling the economy.

"This report undercuts the President's claim that his tax cuts are working," said Sen. Jack Reed, D-R.I.

And finally, Ms. Aversa kills Wall Street:

On Wall Street stocks sagged. The Dow Jones industrials were off 45 points in morning trading.

"The economy's dramatic loss of momentum." I cannot believe I am hearing this right now.

Despite the Dow trading at record all-time highs, the NASDAQ trading at record five-year highs, stocks 'sagged' since the U.S. economy is slowing 'to a crawl'. This is wrong on so many levels. First of all, of course housing is off - markets have shot up the past few weeks like rockets. Where else is the money going to come from to fund equity investments other than alternative investments like houses, bonds (which are down too) and recent commodity gains? Investors are just becoming more bullish and more speculative with their capital by employing it in the equity markets. There's deposit accounts, of course, where the money can come from too, but this is hardly a primary source for capital relocation (why would you put $1 million on a deposit acount paying 3.5% interest when you can throw in a higher-rate T-Bill?).

Secondly, while private investment takes shape in an economy, productivity generally does not increase that much, largely because the result of the productivity is not seen until the private investment yields material returns. With investment only just beginning to pay dividends now, it's hardly fair to say that the U.S. economy is slowing 'to a crawl.'

Journalists do no service to the general investment education of the public not to point these things out, and they do no service to their own economies either. Instead you have to find it on a blog like this. Right now most of the media is scared to point out the latest bullish trends, largely because they fear getting caught and looking ridiculous if the markets plummet again. It's the herd mentality. Steer clear of the herd, and steer clear of overly-simplistic journalism.

NASDAQ at Five Year High

Just as I predicted, we saw a five year high for the NASDAQ yesterday, when trading on the market pushed it up to as high as 2,379.29 points before settling back at 2,379.10 on close - beating the five year by 4.10 points.

With rates looking unchanged - now standing at 5.5% - and billion dollar plus valuations for new unproven tech business models, the market scenario is looking more and more like an instant replay of 1994. All we need now are one or two big IPO's.

*UPDATE* October 28, 2006: Welcome Instapundit readers! Thanks for dropping by. This is a blog about organisations, markets, the global economy and everything in between. Feel free to take a look around, comment and of course, come back!

The Bull Is Back

From the charts, it looks like we'll see a five year high any day now from the NASDAQ - to top 2,375. Last week the market fell short twenty points of that benchmark, but with little resistance in the Dow Jones now, there's a strong chance that some of that industrial buying will pour over into technology.

For the second time in two days, Google has beaten its all-time high of $471.64 - on Tuesday the stock rallied to $484.64, closing at $480.78, and then yesterday the stock reached 488.50 before settling back on close at 486.60.

You don't have to be a genuis to work out that with this kind of momentum behind big tech, a straight leveraged bet on the index weaning out another 5% short-term is money lying on the table. The most interesting candidates in my opinion though are Yahoo!and Lucent.

Yahoo!'s earnings may be much, much weaker than Google's - it trades at a P/E in the low 30's on a market cap of about $30 billion against the latter's P/E of just over 60 valuing the search giant at nearly $150 billion - but the stock has taken a bit of a beating over comparisons with its  younger upstart.

This stock has split no less than 5 times, mostly 2 to 1 since inception - and one of those splits was way past the tech bubble. If big tech continues to plough forward with such mighty alacrity, it's only a matter of time before traders start looking in the bargain bin for P/E's under 40, and Yahoo! is a good contender. It's prescient that Yahoo! doesn't have all the acquisitions baggage that Google has too - even though market sentiment favours recent private equity buy-ups by Page and Brin, they are still one-way bets on unproven brands and semi-proven revenue models. Add to that that the revenue models are pure play with no hedge against the core business model. Also, say what you will, this is a company that's been public through the worst of it all, and there's still a lot of headroom in that chart.

Everyone hates Lucent, but getting in bed with Alcatel was smart - as telecoms markets become more standardised throughout Europe and the U.S.A., having one giant global reach makes sense. At a P/E of 20 and with a market cap of $11 billion, this stock is real bargain basement material right now. When tech picks up, telecoms tech is the next big driver and I think there's a lot of space for some creative earnings streams over the next few years if you're on the content and data side of the business.

Big tech is back, and so is the U.S. economy - it's one major reason the Republicans will storm home in the mid-terms.

Street Games

Like everyone else, I've spent the last few days trying to work out exactly what the DOW surpassing an all-time high of 12,000 points means for the markets. My conclusion is to follow my instinct, and in this case, my instinct is telling me to follow the numbers. The numbers always seemed to be pointing to a year 2012 record high for both markets, fueled by a massive second coming in tech stocks, and it's satisfying that now the numbers are starting to add up in the right direction.

A lot of the skeptics are pointing out - with some justification - that it's not the DOW meeting record highs that's a key indicator, but it's when the the junior NASDAQ follows suit that we should start paying attention. In part, argue the sketics, this is because of the misleading way in which the DOW is measured - as a total culmination of all stock prices regardless of market caps, meaning that an intrinsically smaller company with a higher stock price has more impact on the indices than a larger company with a lower price - and in part it's because the DOW is full of the heavy old industrial stuff which always grows over time anyway and that it's only when the 'New Economy' stocks start rocking and rolling that we know we're in the bull ring. Indeed, The Economist made this point only a couple of weeks ago.

But all this justified skepticism misses some major points, not least historic trends. First of all, there's not a lot of real net difference between a stock price moving up and and a market cap (a company's total value according to outstanding shares) moving upwards when a) the number of outstanding shares of the company's stock issue in play is much greater than the number of privately held shares (as is the case for nearly all DOW companies), and b) when you're trying to guage whether it's buying momentum you're seeing in the markets. Let me explain the second point with an example. If Company A is worth $100 a share but has a market cap of only $100 million, whereas Company B is worth $1 a share but is worth $1 billion, it may be easier to move the price of Company A's stock to $200 than it is to move the price of Company B's stock to $2, but this doesn't mean to say that there's not ferocious buying going on. If anything, it says buyers are becoming more speculative - and hence aggressive - with the returns they expect from their capital by courting assets with lower intrinsic valuations (assuming the comparative valuations of Companies A and B reflect to a reasonable degree their actual assets, which is the case with the DOW).

Secondly,  to dismiss any kind of buying of an industrial capital market as not meaningful enough to guage whether  we're entering a bull market or not is grossly ignorant of the way in which economic growth in an economy takes shape. The first companies to attract investment in China five years ago, it should be remembered, were not the fancy technology stocks  and souped-up financial vehicles that get the spot light in a raging bull market, but rather the industrial companies from which productivity stems. It's only natural for capital to seek out gains in material productivity before it seeks out gains in intellectual productivity.

Most importantly of all maybe, if you look at the correllations between the DOW and the NASDAQ it's impossible not to notice that the latter follow the former in almost acolytic fashion, particularly with regard to up/down swings:

Look at how in particular, in this chart going back to the first trading day of the NASDAQ, the blips in the DOW in 1987, 1990/1991 and 1998 all correspond magically with significant blips in the NASDAQ. Also look at how, after the 1998 blip a strong run can be seen on both the DOW and the NASDAQ. Lastly, and most importantly of all, notice that every time there's a pre-emptive greater spike in the DOW before the NASDAQ follows suit. This is simplistic, but the point is presceint and persistent: it would be the first time in history that the DOW makes a significant gain and the NASDAQ doesn't follow suit if the latter doesn't pick up.

In a presentation I gave earlier this year, I explained the process we are witnessing now this with the accompanying slide:

The last two boxes, "Asset-backed securities" and "Intellectual property" represent equity, the other boxes are their own suigeneric investment catagories. The red arrows represent large-scale and sudden capital departure, wheras the blue arrows represent a timely and more rational movement of capital. Post-2003, the departure of speculative capital in real estate to the equity markets has been a capital transfer that is in part responsible for the growth in the charts above. The most serious stage in the capital markets in terms of capital departure however is represented in the smaller red arrow, where speculative investors leave commodity speculation in order to pursue higher returns in the equity markets. For some time, as the illustration shows, speculators have been toying with commodity speculation supported by a "safety net" of bond-weighted (usually government and AAA) investments.

This is where hedge funds have so dramatically changed the investment platform. Because they are inextricably and comparitively performance-based, once one hedge fund leaps into the equity markets and shows gains, the rest tend to follow. But why pursue equities rather than commodities? Simply because once speculators have realised gains on a base commodity, the next obvious investment is in companies which are benefiting from the rise in these commodity prices. In investing in these companies, they are assuming more risk, naturally, but there's also a higher potential upside: just look at the comparison of the increase in the price of oil and the increases in the prices of oil companies. While oil has showed around 100% rise in price, many oil companies have shown returns of four or five, or in some cases, as much as fifteen times that.

The reason technology is so popular for venture capitalists is that returns are high relative to risk. Technology is certainly risky, but it's not a volatile business with absolutely unpredictable returns, and the market rewards the sector with generally high valuations as a result. From this model, there is certainly an indication that technology is returning slowly to the forefront of the investment world, and that at some point there will be a significant influx of investment towards the sector.

Eddie Elfenbein over at Crossing Wall Street, in a recent post, exemplified stages one and two better than I can here, with charts (which you can see over at his blog):

... the markets suddenly converged in mid-June. Except for a few strays, (there's) a pretty strong positive correlation (between capital exists in commodities and capital introduction into paper). This tells us that money was coming out of hard assets like gold and into paper assets.

And there have been tech stocks roaring their way through the past 18 months. Akamai is one such company. Google is another. The latter's performance is worth considering for a moment. Trading at 473.99 at the time of writing, having beaten Wall Street's expectation on Q3 earnings hansomely only a week ago, it's worth putting under the microscope. This is a company which made a 90% jump in Q3 earnings on the year to $733.4 million, and a revenue increase of 70% to $2.69 billion. While that sounds impressive, the company blew $1.65 billion of those dollars on Youtube, and unknown and untested brand only weeks ago. That's another six month's record earnings at the same level to make the acquisition profitable in absolute terms, without dividends, and without re-investment in its own business. And that's if the concept succeeds. NewsCorp bought MySpace on even more tenuous terms less than three months ago.

All this financing action looks very much like a replay of 1995/6, when Netscape and Yahoo! stacked up one-billion dollar plus IPO prices, except that's it happening in the form of trade sales rather than IPO's. That's predicatble enough. The tech bubble of the 1990's may not have endured, but the impression that the internet is a growth and medium catalyst for hundreds of industries didn't lose any lustre.

My guess is, despite Google's precarious revnue model, the stock spikes $500 before the year end, and a few more 'social networking' sites start charging precarious valuations based on their own one year busines models. That's one billion dollars for one year of relative growth. And when these companies find they can't attract their corporate trade-buyers, the next logical thing is to find VC's looking to cast-off their gains in the retail market. Or the VC's already financing this stuff will start to get bored with the lack of liquidity generally available in a trade sale. Or they'll just look for higher gains, from greater fools. Ridiculous or not, it's the trend of the market.

Last time round the argument was that rates had so far to fall that it couldn't possibly be a bubble. This time round the same argument is contsruable with commodity prices and lack of inflation. Whichever way you see, if you want to argue a five-year bull, the stats are there to make it believable, at least for a cyclicar five year term.

Let the games begin.

*UPDATE* October 28, 2006: Welcome Instapundit readers! Thanks for dropping by. This is a blog about organisations, markets, the global economy and everything in between. Feel free to take a look around, comment and of course, come back!

Greed is Good and DOW 12,000

As the Dow Jones makes history surging past the 12,000 mark yesterday, it's just too irresistable not to join in all the bonhomie and play back that famous speech delivered by the fictional Gordon Gekko (Michael Douglas - not that anyone needs reminding) in Oliver Stone's classic Wall Street:

There are still some amazingly relevant points in the speech, not least of all that "we're not here to indulge in fantasy, but in political and economic reality. America ... has become a second-rate power. Its trade deficit and its fiscal deficit are at nightmare proportions." The solution al la Gekko? "Greed ... Greed is right. Greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms - greed for life, for money, for love, knowledge - has marked the upward surge of mankind. And greed - you mark my words - will not only save Teldar Paper, but that other malfunctioning corporation called the USA."

It seems that Greed is still very much the vogue remedy for hard times. Saying that, let's not start counting to 36,000 just yet.

Is The Slippery Commodity Slipping Up?

Nearly - but not quite - time to gloat.

Oil Prices Retreat; natural gas at three-year low
LONDON Oil prices retreated Tuesday after an overnight rally lifted crude futures by almost US$1 a barrel on worries that the recent drop in prices could prompt OPEC to cut production. Natural gas hit a new three-year low.
Oil prices are down 21 percent since hitting a record of US$78.40 on July 14.

I've thought oil prices were way too high and headed for a fall for a long time now (here and here). The principal reason isn't so much that emerging market growth rates are slowing as it is that oil is driven by two types of demand: genuine and speculative. The overall genuine demand for oil - i.e. demand created by higher fueling requirements as a result of increase in number of cars on the road etc. - is certainly on the increase, but for far too long, the speculative demand, created by traders looking to make a quick buck, has been far too high.

Speculative demand is put about by two principal fears: that the emerging economies will end up consuming all the world's natural resources in their unstoppable path to world financial domination, and that terrorists accross the middle east are going to blow up Israel or America or Britain. Both these scenarios, we know from a reasonable assesment of history, are less likely than the counter-scenarios of terrorists running out of money and support for their causes, and emerging economies just running out of steam - at least to a point of relative stagnation. There's also a lot of confusion in the middle east fears too. Principally, it's that terrorists do not control oil, big companies do. Terrorists have no real power to shut off the world oil supply. And countries like Iran and Venezuela are hardly likely to turn off the taps either, given that it's pretty much their only source of income.

While the scenario of OPEC cutting supply is likely, it will only be in parity with genuine demand, which should in theory leave no net effect, which in turn should leave that layer of speculative capital out to dry. Amid the speculation, there's been talk of every type of inconceivable invention, even a Euro denominated Iranian oil market to compete with US commodity derivatives exchanges.

Now the speculative capital is starting to ease out of the markets, predictably enough spiking and deflating. My guess is that the oil price will probably hit a low of $35 and bounce back up to stabilise at $45. If this sounds unbelievable, it's worth remebering that it was unbelievable too once that fiber optic cables - that commodity which was about to hold up the entire communication infrastructure of our world - would one day be practically worthless.

*Update - October 01, 2006* And there's more. Apparently, some stations in Knoxville, Tenesse are selling gas for under $2 now. (Via Instapundit)

Whose Next In Line At HP?

Given HP's penchant for putting women in the top spots, I'm amazed no one has asked whether newly appointed Chairman Mark V. Hurd is going to continue to retain his joint title as Chairman & CEO, or whether a new CEO position will be created within HP -- to be perhaps filled by a current female senior executive.

One thing is for sure, if this is the case then HP will consider its options carefully. The disasterous appointment of Carlton Fiorina as chief exec 1999 and her subsequent appointment as Chairwoman lasted only five years before the company had become deeply divided over its intended strategy. Robert Wayman then stepped in as interim CEO, before recently sacked Chairwoman Patricia Dunn was put in place just above Mr. Hurd as CEO. It's no secret that HP likes the idea of a woman at the top. Execs at the time of Ms. Fiorina's appointment were criticised for looking to hard to find a female Chairman & CEO, which was allegedly at least in part the reason for the division of the jobs in the 2005 nomination process. Now, with the recent wire-tapping scandal, the nightmare seems to be re-living itself, just with a different plot this time. Dealbreaker is staying up-to-date.

I contacted HP earlier today to ask them if there were any further intended personnell changes, but so far I still haven't got a response. I'll update here if there is one. In the meantime, it's worth checking out the current roster of top female candidates (the following is an aggregation of their biogs from the HP website):

Ann O. Baskins - General Council

As HP's general counsel, Ann Baskins manages a global function responsible for worldwide legal matters including patents and licenses, litigation and regulatory compliance. As corporate secretary, she is responsible for annual shareholders' meetings, board of directors' formalities, corporate governance issues and shareholder records.

Baskins joined HP in 1982 as an attorney in the company's Legal Department in Palo Alto, Calif. She was named a senior attorney in 1985, corporate counsel in 1986 and held a number of positions in the department prior to becoming general counsel in January 2000. She was elected assistant secretary of the company in 1985 and became the corporate secretary in 1999.

Baskins holds a bachelor's degree in history from Stanford University and a law degree from the University of California, Los Angeles.

Ann Livermore - EVP, Tech Solutions

Ann Livermore leads HP’s Technology Solutions Group, a $33 billion-plus business that encompasses storage and servers, software and services. The products and services from this organization serve HP’s business customers of all sizes in more than 170 countries.

Livermore has been involved with HP’s business customers for more than two decades, building customer relationships and information technology solutions to help customers manage and transform their IT environments. Livermore joined HP in 1982 and has held a variety of management positions in marketing, sales, research and development, and business management before being elected a corporate vice president in 1995.

Originally from Greensboro, N.C., Livermore holds a bachelor’s degree in economics from the University of North Carolina at Chapel Hill and a master’s degree in business administration from Stanford University. In 1997, Livermore was elected to the board of directors of United Parcel Service. Livermore also serves on the board of advisors at the Stanford Business School. She is based in Palo Alto, Calif.

Cathy Lyons - EVP & Chief Marketing Officer

Cathy Lyons, executive vice president and chief marketing officer of HP, is responsible for the company's comprehensive global marketing strategy. She leads HP's worldwide branding efforts and drives all its marketing initiatives, including external communications, internal communications, brand marketing, marketing strategy and excellence, corporate affairs, region corporate marketing, and total customer experience and quality. Lyons also leads the Global Marketing Council, comprised of marketing leaders from the businesses and functions as well as Corporate Marketing.

Previously, Lyons was senior vice president of Business and Imaging Printing, a global business unit in the HP Imaging and Printing Group. Prior to that, Lyons was vice president and general manager for the Inkjet Supplies Division, where she managed and directed development, manufacturing and marketing operations for the consumer and commercial inkjet business.

Lyons was also vice president and general manager of the Supplies business, where she directed worldwide business operations for multiple imaging and printing platforms, including ink, laser and print media technologies. In this position, Lyons also was responsible for directing a separate original equipment manufacturing organization that leveraged proprietary HP ink technologies into new industrial markets.

Before joining Supplies, Lyons was general manager of HP's LaserJet Solutions Group European operation in Bergamo, Italy, where she was responsible for creating the concept of digital sending. HP Digital Sending technology eventually grew to become a standalone business and today is integrated into HP's award-winning multi-function printers.

Based in Boise, Idaho, Lyons is a graduate of the University of Colorado, where she earned a bachelor of science degree in business administration and marketing.

Marcela - EVP Human Resources, Marcela Perez de Alonzo

Marcela Perez de Alonso has worldwide responsibility for HP's human resources initiatives, including workforce development and organization effectiveness, benefits and compensation, staffing, global inclusion and diversity, and HR processes and information management. She also is a member of the board for HP Financial Services, the financing arm of HP.

Since joining HP in 2004, Perez de Alonso has spearheaded a pivotal transformation to build a best-in-class HR organization aligned to drive results and optimize the company's growth and efficiencies.

Previously, a long-time executive at Citigroup, Perez de Alonso has held senior-level roles in both operations and human resources, including the lead HR role for Citibank's Global Consumer Business - a 90,000-employee organization where she developed a host of breakthrough initiatives. Senior executive recruiting, diversity, variable compensation and employee survey programs are among the many worldwide efforts Perez de Alonso led during her tenure. She also was head of Citigroup's North Latin America retail business operations and was in charge of deposit products for the company's international retail bank.

One of only 10 women to be included in the ninth annual Hispanic Business Corporate Elite directory, Perez de Alonso was named one of the 50 Most Important Hispanics in Technology and Business by Hispanic Engineer & Information Technology magazine. She also was honored as the 2005 Corporate Executive of the Year by Hispanic-Net, a California nonprofit organization of executives and professionals in technology-related fields.

Perez de Alonso earned an advanced degree in organizational psychology from the Catholic University in Chile. She attended the Business Executive Program of the Columbia University Graduate School of Business and received a certificate in finance and accounting.

Perez de Alonso is on the advisory board of the Marshall Business School, University of Southern California. She also is a member of the board of Next Door Solutions to Domestic Violence, a charitable organization serving Santa Clara County in Northern California.

Ann Baskins would be an unlikely appointment, seeing as she was (at least nominally) in charge of both the Kona I & II investigations which have caused this whole fiasco in the first place. My money would be on Cathy Lyons, given HP's intense focus on marketing and branding, and the fact that she hails from the printer side of the business, which has felt like the much ignored bedrock of the company in recent years. Then again, given  the state of affairs that seem to keep popping up, perhaps having a someone with human resources experience as cheif exec would not be such a bad thing.

*Update* Ryan J. Donovan, from Corporate Media Realtions at HP has responded to my questions - the following are the questions and answers:

Q: Since Mr. Hurd has now assumed the role of Chairman as well as CEO -
are there any plans to create a new CEO position or will he remain the
Chairman & CEO?
A: He will remain Chairman, CEO and President.

Q: Is he acting Chairman/CEO or full-time?
A: Full time.

Q: Any other personnell changes to be made?
A: Not at the Board level beyond Pattie Dunn's departure.

Q: What's the order of seniority of the following in the management
team? (i.e. who is most senior or are all positions pretty much equal?):
A: You can find a complete listing of levels on hp.com.

Well, seemingly no more changes, and operations as normal. Personally, I still wouldn't be surprised to see some more changes as time goes on. I'll update with more responses from employees/ex-employees soon. The last point too is not true, incidentally - while you can find an adequate list of management on the website (the same link I gave above when reffering to the management biogs), you cannot find the actual heirarchy of that management.

Somone Has To Pay For It All

It's not always just consumers who can't pay their bills. At least, according to a Reuters newsflash today on Zimbabwe, this seems to be the case. "Internet traffic in Zimbabwe has come close to a standstill after an international satellite firm slashed its bandwidth because the cash-starved government failed to pay the bill," the wire reports.

Government-owned TelOne, which owns the country's main satellite Internet link, said satellite firm Intelsat had cut its international bandwidth because it failed to pay the $700,000 fee.

"The link is slow because they reduced the megabits on our satellite link until the payment is made," TelOne spokesman Phill Chingwaru told Reuters on Wednesday.

... "It is a nightmare because of the congestion and we are getting calls from desperate clients, some of them who can't even access the Internet," said an official from a private ISP, which uses TelOne's satellite link.

As the report further points out, Zimbabwe's 1200% rate of inflation and 70% unemployment are the principal drivers behind such calamaties. The story is a great reminder that technology - and indeed any scientific development - is not free of charge, even when its infrastructure has already been implemented. Too often in developed economies we tend to think that no matter what happens, as long as we remain relatively protectionist and guard our assets sufficiently, the chances of any kind of real reversion of development is minimal.

Zimbabwe is a great counter-example to this over confidence. It is precisely liberalised trade that has brought us the technological developments which improve our lifestyles, and all asset guarding tends to do is create a barrier towards growth of commerce. Granted, Zimbabwe is also run by a dictator who hoards many of the country's assets himself, but even then, was the country open to foreign trade it is highly unlikely it would be in the kind of mess it finds itself in now.

The key difference between the world of the twenty-first century and the one of the centuries before is our high degree of interdependence. Intelsat - the company which cut off Zimbabwe's connection - is a Bermuda-based global providor of satelite communication, a whole two oceans away from Africa. It's a story worth remembering - especially in light of current talks of protectionism in response to other fast emerging  powers, which again, are a couple of leaps of the pond away.

The Price Of Space

Since News Corp. purchased MySpace for $580 million in July, you can't help but feel pundits are getting a little hysterical about the potential for online 'social networking' sites. Over the summer, there has been no end to the fanfare of publicity from everything hailing Rupert Murdoch as a visionary genius making bold moves in a rapidly changing industry to more 'it all began in a garage' stories.

Investors should be wary of the publicity supposedly educating them all about the potential ad revenue for social networking sites, though. For when you go and blow over half a billion dollars on a company which few think has any substantial assets other than a rote of fairly standard hardware servers (and that's an accurate analysis), you tend to want to tell the world just why you think it's worth so much. Thus has been News Corp.'s mission so far, spewn across a number of supposedly informative articles detailing the enormous advertising power of such sites.

And the current talk of other social networking sites' valuations - like Bebo and Facebook - appears to be a little misleading right now too. The Economist editorialises this week that the acquisition of MySpace "now looks like a masterstroke" and chimes in the speculation that one of the reasons for CEO Tom Freston's sacking from Viacom was because of his reluctance to pay the huge asking price for Bebo, which would have added a much needed online dimension to the owners of MTV's stable of media outlets. But the criticism misses the point, and Sumner Redstone is a very foolish man indeed if this decision was at all responsible for relieving Mr. Freston.

The reason News Corp.'s acquisition of MySpace now looks smart is principally because other social networking sites have been able to up their own valuations based on that one deal, and now it's a rush to see who can sell in this heated climate. There's a good reason Mr. Freston didn't want to pay Bebo's asking price - probably because it was too much. And $580 million was most likely too much for MySpace, too, given that this is a company with no proven long-term business model and no irregular or unusually valuable assets other than a one-year old brand name. And a hundred and twenty million users, of course. But the hedge fund world - where analysis is often ultra-short term - has a saying that goes something like 'if you can make it in a year, you can lose it in a year'. News Corp. - and investors - would do well to keep this in mind right now before picking up any more unproven brands at unproven prices.

Orkla and Mecom

If there’s one British name which nearly every Norwegian is by now familiar with it’s David Montgomery, former editor of The Sun and News of the World, CEO of the Mirror Group and, since 2000 founder and executive chairman of Mecom Group, the AIM-listed media acquisitions and development vehicle. Since Mr. Montgomery agreed to purchase Orkla Media from Norwegian conglomerate and national institution Orkla at the end of June, the self-styled media tycoon has been the catalyst for hundreds of column inches of debate over the ethics of selling national publications to foreign proprietors, the fate of the country’s press, and most recently, whether the deal is going to go through at all.

Norwegians can be forgiven for all the drama. Montgomery’s proposed million Euro acquisition has not been smooth by any account; more mixed still have been the messages both Mecom and Orkla have been sending out over the past month. At first Mecom’s ownership of Orkla Media – whose empire is spread across Norway, Sweden, Denmark, Finland, Lithuania, Poland, Ukraine, and Germany, making it the fifth largest media conglomerate of the Nordic region – seemed like a foregone conclusion. On June 28, Orkla made a simple announcement of the sale in a press release, stating financial details were still under negotiation. “Mecom’s offer for Orkla Media is financially attractive for Orkla shareholders,” said CEO of Orkla Dag Opedal. “Furthermore, the solution is satisfactory with regard to the other goals that were set for the process. Based on an overall assessment, this is therefore the best solution for both Orkla shareholders and Orkla Media.”

Less than a week later, on July 3, Orkla announced that the sale would be for 7 billion Norwegian Kroner (about £614 mln), and that the parent company would be taking a 15% share and one seat on the board of the newly formed Mecom Europe conglomerate, which was to be headquartered in Oslo and run by existing Orkla Media Managing Director Bjoern Wiggen. Orkla Media would be valued at 7.5 billion Norwegian Kroner “after adjustments for cash and other financial capital”. Mr. Montgomery announced his plans to raise the money through a combination of debt and equity, giving the new entity a “leveraged buyout structure”. The deal was supposed to complete and sign last Monday on the evening of July 17, with a press conference planned for the next morning.

It’s at this point the deal began to look uncertain; that press conference never took place. The parties announced that lawyers were still finalising the deal, and that the agreement was “large and complicated, with many elements to be put into place.” Nevertheless, Orkla Media director Stig Finslo was confident; “We will finalise the agreement,” he said. Danish newspaper Berlinske and Norway’s largest financial daily Dagens Naeringsliv reported soon after that Mr. Montgomery was having trouble raising even half the money required for the acquisition, with several previously committed funds having gone weak on the deal. Orkla’s Chairman – and Norway’s richest man – Stein Erik Hagen announced from his holiday break that “we’re still following the timeframe we set up.”

This weekend came confirmation of the problems associated with the deal however as Mr. Opedal caught a plane together with a lawyer and an accountant from the company to meet Mr. Montgomery and try to iron out the problems. On Saturday, Mr. Hagen then made a surprise announcement to Dagens Naeringsliv that Orkla had a back-up plan if the deal with Mecom fell through. “We have a plan B, but I don’t wish to disclose the details,” he said.

In yet another about-turn, the mood yesterday evening after this weekend’s talk was suddenly more upbeat. “(Mecom and Orkla) have worked through the whole weekend on a possible agreement,” Mecom’s spokesman Eric Cameron told the Norwegian news wires just after six London time. “The talks have mainly taken place here and have been productive, but it is too early to say when we will reach a decision. It will take as long as it takes.”

The question is then, what’s going on and even more presciently, is this deal going to happen at all? Certainly, there are members on both sides that desperately want it to go through. For Mr. Opedal, who has been chief executive of Orkla for less than a year, this is just the kind of lucrative international deal he has been looking to make his mark with since he took over from his short-lived predecessor, the more conservative Finn Jebsen. It is widely cited inside Orkla that Mr. Opedal is the company’s next  Jens Heyerdahl, the entrepreneurial and dynamic former Chief Executive who from 1979 until 2001 turned the company around dramatically from a medium-sized mining operation into a full consumer-goods and specialist metals manufacturer. Selling to Mecom would be a savvy move: it would give Opedal a substantial amount of money to pursue his own vision for Orkla while at the same time retaining a minority – but still valuable – share in a profit-hungry European media enterprise.

Orkla media currently operates at a 7 – 8 % profit margin; it is Mr. Montgomery’s hope that he can turn this around to 15% in fairly swift order. The problem for Mr. Opedal if he were to pursue this himself would be in harming the very close relationships with unions which Orkla has enjoyed since it’s days in the mining business. What’s more, this deal flies very well with the traditonal corporate philosophy of the organisation – “ownership is more important than structure” is a frequently cited maxim inside the company’s walls in Skoeyen, Oslo.

For Mr. Montgomery of course is the chance to own one of the largest European media conglomerates in the world, and firm up positions in Germany since his controversially-received acquisitions of Hamburg Morgenpost and Berliner Verlag earlier this year, and at a comparatively low valuation (analysts have put previous valuations on Orkla Media at well over £700 mln). Battling unions is not shy territory for the former Murdoch employee either.

Perhaps most presciently of all, the deal works as mutual back scratch: both Mr. Opedal and Mr. Montgomery are young Chief Executives out to prove that they can make a mark not only in their own industries but on an international playing field. Mr. Montgomery has almost entirely ignored the UK newspaper market since founding Mecom. This accounts too for the apparent strategic discrepancy in Mr. Hagen’s statement made on Saturday and the more affirmative ones consistently made by Mr. Opedal. If both entrepreneurs wish to close this deal, they will have to quickly.

The issue seems to be almost unequivocally one of cash. In March this year, Mecom suspended its stock and announced a rights issue to raise £145 mln at 50p per share. Two months later, it had only managed to get together £70 mln at 48p per share.

The suspension of the stock remained on grounds of plans of a “major acquisition”. The previous acquisitions of the German dailies were majority partnered by American private equity firm Veronis Suhler Stevenson, since Mecom blew most of its cash on the £200 mln acquisition of Dutch LMG from Telegraaf Media Groep. If Mr. Montgomery cannot borrow or raise sufficient cash then, what are the options? This was most likely the issue on the table this weekend.

A potential solution which Mr. Opedal may have offered Mr. Montgomery is for Orkla to loan Mecom the money itself; assuming Mecom can front up half the cash, borrowing 3.5 bln Norwegian Kroner (about £307 mln) at a standard corporate bond rate of 8%, Orkla Media would still yield (albeit slight) annual profitability of £10 mln with current revenues of 8.7 bln Norwegian Kroner (about £763 mln) until Mr. Montgomery can raise the cash to pay off the loan.

If he hit his projections for doubling the profit margin, the company would be in very healthy financial shape, even without paying off the loan. This deal is about personal interest and politics as much as it is the bottom line, which is why perhaps it has been so adamantly presented as the latter. All that remains to be seen is whether the two chief executives at the front of it can pull it off in time. This will prove the first valuable test for both their ambitions.

Too cheap?

Philips Electronics’ announcement this morning that it is buying back 1.9 billion EUR of its own stock after the price fell on the announcement that quarterly profits were off 69% may signal confidence but it should not yet be misconstrued as a signal to pick up the shares.

Although operating profits more than doubled this quarter to 367 million EUR and sales were up 10%, the figures do not look quite so bullish when set aside the most recent yearly financials: at the end of 2005 operating profits were off more than 30% and sales had fallen by nearly half that; in addition, catch-up with end-of-year 2004 numbers is still some way off.

Rather, what this signals is just how difficult  it is to make money in the overcrowded and brand-dominated markets – and in particular the semi-conductor market – in which Philips operates. At first glance a P/E of 10 seems to be pretty cheap for the proprietor of the successful LG brand and more broadly speaking for a company in the heavily traded tech sector right now, and one almost understands CFO Sivignon’s announcement that the valuation is “attractive” – until, that is, one looks closer at the earnings.

2004, the big year so far for Philips, was most notably marked not by a substantial increase in product sales or even a sharp spike in gross margin on products sales (both of which grew steadily), but by a dramatic uplift on interest earned from equity holdings. This is a wary form of income for a business where market share and brand dominance is everything.

Philips’ sale of its stake in digital map maker Navteq last year – which trades at twice the valuation of the former – was a necessary move, but it is up to Sivignon once again now to prove to shareholders that he can effectively invest the cash in R&D and marketing to offer a substantial threat to goliaths such as Sony, Siemens and Texas Instruments, all of which trade at a minimum of one and a half times the price and all of which focus heavily on the former two departments. CEO Gerard Kleisterlee’s 3 billion EUR plus acquisitions binge this year may be expanding the size and scope of the company, but unless that expansion is paying off in terms of profit margins derived from product sales – rather than short term bets – it’s a meaningless indicator of the long-term prosperity of the company. 

It’s the age-old rule of quality of earnings. In a sector where depreciation of unsold goods is about as high as it gets, and where brand loyalty is as flighty as the next new new thing (as evidenced by LG’s sharp wake-up call on July 11), Philips’ focus on strengthening product quality and innovation and perception of product quality and innovation needs to defined more clearly before the shares look cheap. Spending some of these billions in development and marketing must follow next.

Slovenia

The EU's formal announcement today of Solvenia's inclusion in the European currency fold may look like just another natural step in the direction of long-planned regional growth - and indeed this is exactly the kind of low-profile way EU party members want to make it appear - but the addition of the former Yugoslavian member state is one of the most significant moves in Europe in a long time. For a formerly volatile political hotbed, Slovenia's economy appears to be in remarkable shape: with a GDP per capita income of 12,000EUR at a real growth rate of 3.8% and with national deficits of less than 1.7% of GDP, the country has weathered only recently acquired independence better than most. This is partly due to exceptional trade relations with Europe, and partly due to the country's unique geographic positioning and fair natural resources: at the intersection between the Balkans, central Europe and the Mediterranean Slovenia has been able to benefit off increased European demand for raw materials, in particular raw material assembly on the cheap.

Most significantly for Europe, however, Slovenia posesses all the economic indicators that buck the negative macroeconomic trends the continent wishes to try and steer clear from as her transatlantic neighbours seem barely able to cope. Increasing privatisation in the country has led to a decline in inflation by two hundred basis points over the past two years (when Slovenia's acquisition of the European currency was first formally proposed), unemployment is falling sharply and privatisation of state assets is aggressively being undertaken with relative ease. In addition to this, Slovenia's unique cultural and political relationships with the Ukraine and Russia give Europe economic front-door access to investment in a wider oil-rich Eastern European economic region.

Most pertinent of all, however, is Slovenia's import and export market: with over two thirds of trade concentrated with mainly Germany, France and Italy, and just under 3% of trade with the United States, she makes for the perfect "New Europe" model.

EU legislators know that if they can only get another few "Slovenias" on board, they stand a chance at curbing global inflationary trends while simultaneously accessing growth markets in politically neutral ways; something Uncle Sam has never been able to fulfill in one sweep. The accession of the European currency in Slovenia is both significant and timely.

Geopolitical WHAT?

From The Street:

Wednesday's drop in crude oil -- and the metals -- came after the Energy Department reported an unexpected rise in U.S. inventories of gasoline and oil in the latest week. In recent action, crude oil for June delivery was dropping $1.46 at $73.15 a barrel.

But the standoff between Western countries and Iran, the world's fourth-largest producer of crude oil, continue to provide support both for crude oil and gold. The precious metal acts as a hedge against inflation and as a safe-haven asset amid geopolitical uncertainties.

Someone tell me, WHAT genuine geopolitical uncertainty is there in the world today that hasn't been around for the last fifty or so years, since the Iran-contra affair? It's not as if the world is any less safe today because of terrorism: terrorist networks have just been replaced by other terrorist networks which have become dormant. Has everyone forgotten about the USSR "standoff" too? This was a lot more serious than the standoff between Iran and the west: if western countries really needed to, they have the military power to shut Tehran down overnight.

All-time-high commodity prices in light of geopolitical uncertainty is ludicrous when you think about the reality of it. If this is genuinely a major driver for the rally in commodity prices (and I don't think it is as much as China's growth, and even here there are strong signs that this is only being kept at its current rate by foreign investment) then it's only a matter of time before we'll start seeing bargain-basement prices for raw metals and oil.

Norwegian and Global Equity Markets: Heating Up

Last Wednesday I gave a presentation to Norway Business Club (Norway BC) in Oslo. I have been meaning to put it up, but I've been busy with various things (like going to see Norwegian demonstrations). Open BC is basically an online business networking service, which began in Germany but now encompasses a large group of entrepreneurs, venture capitalists, academics and consultants all over the world. This was the first meeting ever of the Norwegian Business Club, and it was my priviledge to be presenting at this prestigious event.

Here is a summary of my presentation, titled "Norwegian and Global Equity Markets: Heating Up", with some additional commentary presented under each slide.

Standard & Poors: low on growth, high on value

There's a fascinating quick-and-dirty piece of anlaysis up over at Ticker Sense, illustrating just how undervalued the U.S. equity market is right now:

... of the seven recoveries since 1962, corporate profits have risen at a faster pace than any other recovery since 1962. Clearly investors should be bullish, right? ... investors must have gotten up on the wrong side of the bed at the start of this recovery, and have been in a sour mood ever since. Since November 2001, the P/E ratio on the S&P 500 has not only grown at a slower pace than any other expansion, but it has actually declined!

Illustrated with charts, and well worth checking out. One possible explanation for the undervaluation of such apparently profit-rich markets right now is that the money is geared towards growth, and despite the fact that the S&P seems to be recovering well, the general perception is that there's not a lot of potential growth when compared alongside other, more exotic markets like China. Bear in mind too that in the 1970's many of the companies listed on the S&P 500 were actually growth companies back then, and by implication merited higher P/E ratios.

Taking into account the fundamental changes in the dynamics of the S&P then, the key question is probably not when S&P stocks will pick up but where all those excess recovery profits are re-invested: it's all about capitalising off innovation as a value company.

Chinese Charades

The Stalwart has an excellent explanation up of the over-heating of Far Eastern emerging equity markets in light of institutional  funds which have promised investors continual investment in these markets no matter what the cost:

But then you have to remember that once again, when money is allocated to funds which have a strict mandate, it needs to be invested no matter what. Thing is, who says these countries have enough listed companies in order to accommodate this sudden shift in funds? Perhaps they're already fully valued. Perhaps an emerging market is only US$200bn in total. What then happens when suddenly a few billion dollars needs a home within 6 months?

Basically, one has to imagine that fund flows can change in magnitude by large, say 20%, increments per year. But on the flip side, an economy can supply only so many new businesses for sale per year. Economies build value in smaller, more steady increments. Without a boom of truly valuable IPO's, we're asking for trouble when suddenly a ton of americans decide they need a re-allocation to Asia. The result? Expensive emerging market stocks get bought just because they have to be and get ever more expensive. Small market + big foreign flows mandated for rapid allocation = bad companies in volatile economies rise to valuations at or above larger, stronger, more stable ones back in the US.  You pay the portfolio manager big bucks to be smart, but then he is forced to just invest along a mandate and buy his index.

This is an exact replay of what happened pre-1997 in Asia, except that time round it was in the private equity sector. In the early 1990's funds began promising multi-millions of dollars returns by buying into South East Asian (and in particular Chinese) private equity, only to find that most of the equity just wasn't there after they had found a place for the first 10% or so. The private equity funds were then forced into commiting their capital at no matter what cost. Instead of turning the funds away empty-handed, emerging economies made the situation worse by manufacturing private equity deals which could be legislatively contsrued as reasonable private equity investments, but which were in fact, not worth the paper they were written on.

China's continued encouragement of foreign investment should sound warning bells to anyone thinking of joining the Eastern rush at this stage, for this time round, the situation is potentially more perilous. Since this is publicly tradeable - and therefore quoted - equity which is being sold hard to emerging market investment funds, it adds another dimension to the boom-bust factor. At least last time round there was a limit to how much private equity could be sold to foreign funds before the game was up and investors realised what they owned was worthless, since there is no speculative capital gain to be derived from private equity unless you can source another buyer. In the case of this publicly tradeable equity however, funds are showing worthless paper capital gains on these foul investments, giving investors in the funds the impression that performance could not be better, and this in turn only encourages more good money to follow the bad.

Of course the governments of these emerging economies are only too aware that as long as they keep encouraging more foreign investment into the region, the game is not up. Unfortuneately for foreign investors, the longer this charade goes on, the more are going to feel even heavier consequences.

Manipulating The Facts

The lack of financial sophistication of so-called business journalists astounds me sometimes, particularly when they come from a reasonably credible publication like Business Week. This week Heather Green analyses a new finance blog concept by AOL called Blogging Stocks. Blogging Stocks is, as Green explains well enough, "a unique idea. AOL hired bloggers to write about product announcements, earnings releases, and commentary on 8 stocks initially. On its first day, the network will do live blogging of the Microsoft earnings call, for instance. (Good luck!)" This is interesting news, and worthy enough of publication.

But then Green launches into a bizzare analysis of conflict-of-interest ethics at the new blog:

So, what about the $64,000 question? Can the bloggers hold the stocks they are writing about?

Indeed. In fact, AOL encourages them to be stockholders, if not necessarily in the companies they're writing about. The key is that they have to sign a code of ethics, disclose their holdings and not trade on insider information, says Marty Moe of AOL Money & Finance.

Here's where my old school training kicks in. Different media outlets have different policies. But it's verboten for me to cover a company in which I have stock or that my family has stock in.

And yet....this is a new world. It's up to people following these blogs to decide whether they feel any stock manipulation is happening in the comments. That's like newsgroups already out there. But AOL will also be monitoring its bloggers, which is different and adds a need for a level of skeptism, I think.

This is not the first time a Business Week journalist, or even a professional business journalist for that matter, has posed the question of potential stock touting and market manipulation on behalf of bloggers.

There is a good reason AOL don't particularly care whether the writers for their new blog hold shares they are promoting, and that is that it would be impossible to manipulate most of them. Let me explain why.

Microsoft stock, for example, is bought and sold, on average, in quantities of between 59 million and 65.5 million shares a day, depending on whether your source is Yahoo or Google Finance. That figure equates to around between $1.4 and $1.6 billion worth of stock. Let's suppose then that one wanted to manipulate Microsoft stock through a blog post: assuming that a 10% increase in daily volume would move the stock up or down a few points (depending on whether your agenda was to encourage buying or selling), stock manipulation in this case would require parties who had read your post to cumulatively purchase or sell at least $150 million worth of Microsoft shares. Unless you're Jim Cramer or Barton Biggs, you'd be lucky to see someone part with $10,000 as a result of something you wrote about a share.

Which brings us to the next point made by those who claim that blogging may manipulate stock prices: suppose you hold a stock which has no volume, and you want to manipulate the price of it by encouraging a few punters to part with, say $5000 - $10,000. For a start, anyone remotely familiar with investing will look at this equity's daily volume and conclude that it's a dog, but even if they don't, the tout of the stock would never want their name  associated with it since it most likely is a complete dog and no one will ever listen to them ever again. Furthermore, even when did try to sell their own shares as a result of the price moving up on the back of their tip, they would be moving the price down by doing as and end up with pretty much what they paid for them.

Green's sensational conclusion that there "is a need for a level of scepticism" is just plain wrong: market manipualtion is nearly impossible if you have no name and no connections, and therefore not even worth speculating about. Business Week journalists ought to know this, and in the very unlikely chance they do not, should not be working there and writing about financial markets at all. It is, after all, about the most basic law of economics: supply and demand. Where this type of article looks sinister is in the fact that they are aware of this and are just trying to create sensationalism and hype to move stories: who, after all, is not interested in a story about AOL, market manipulation and blogs?

So how have message boards become instrumental in moving stock prices then? Not through ramping shares, but through the disclosure of genuine, secret insider information made on them that encourages buying in the stock, but that's a completely different thing altogether.

Growth Vs. Value

Crossing Wall Street makes a good point about tech giants Microsoft and Dell this week:

In less than a decade, Dell and Microsoft have gone from growth stocks to value stocks.

Shares of MSFT are getting ripped today (Friday) in the wake of the company's third-quarter earnings report. The company earned 28.6 cents a share, which rounds up to 29 cents, but that includes a 2.6-cent charge for stock options. The Street consensus was for 33 cents a share.

The stock is currently down over 11%, its worst day since 2000. As bad as Microsoft is, Dell just don't make no sense. The stock is down to $26 a share! One of the things I've learned about investing is that trends can go on longer than you think. Everytime you wonder, "how much more can this go on?" it will.

Dell was at this price eight years ago, yet the company's sales and income have tripled since then.

Generally, when there is more gowth in the market than value, this is what constitutes a bull market, and when there's more value than growth lying around, it's a bear market. A healthy market is a balance between growth and value, and so is a healthy company: it's a sign of a solid organisation when it makes it past the growth stage and into the value stage, since growth usually comes at a cost which investors end up overpaying for. The real challenge for organisations like Dell and Microsoft now is to create innovation in microcosms of their value chain and benefit from a variety of offshoots of growth without compromising on the core assets of the business which make them so competitively resistant to the short-term market trading cycles their younger growth siblings can't weather.

The same is going to be the case for markets in the Far East, where growth is outstripping value right now at an unprecedented pace. If the asset-rich  companies of say, the Shanghai stock exchange can somehow find a way to become innovative at the right price in the right areas of their value chains while the going is still hot, this would prevent the Chinese economy from the fast overheating it's currently experiencing.

This is easier said than done, however. The twist that makes the transition from growth to fair value so hard is that just when value companies are being pummeled by an exuberant short-term trading mentality, growth companies are usually being rewarded with massive valuations. What this ultimately means is that either value companies end up over-paying for the price of intellectual capital and innovation, or they end up short of the whole venture altogether and stuck with traditional value chains which keep them in the same rut they got themselves into in  the first place.

A possible way out of this vicious cycle remains yet to be proven in oil and energy companies.  Oil stocks have been rewarded hansomely for their increases in profits due to the high oil price over the past 18 - 24 months; if as a result of this capital injection they can show that they are funding and developing alternative solutions for newer, cleaner energy sources and capitalise on that investment once the price of the black liquid shrinks again, this will be a very positive example for large organisations to follow. It may, in fact, be the first time in history where organisations have successfully taken advantage of the disruption happening to their own traditional business models by siezing and taking control of it first.

The process requires leaving some cash on the table, and this is difficult for institutions like Microsoft and Dell, who still think of themselves as growth companies, to do. But ultimately, it's cash on the table or cash in a new entrant's pocket, or worst of all, a giant macro-level cash exodus - as Bill Gates knows only too well, and as many entrepreneurs in the currently growth rich Far Eastern economies are about to find out.

Cramer on Technology

Jim Cramer thinks the tech rally the market is enjoying at the moment is not sustainable:

The group's got no momentum going into the summer and given that there is no Vista in sight, you lose a lot of the reason to buy. The buying is concentrated in FTTP and some cell-phone stuff, mostly because of competitive forces (cable vs. telephone, telephone carrier vs. telephone carrier).

I think that anything away from those two sectors in tech is just a trade. I sure wish I could be more bullish, but PCs have become like mid-ranges in the previous decade; they don't work as a theme. And the Web seems to be off and on.

Cramer may well be right, but equally the rally has only just begun starting to happen, and it's worth bearing in mind that the way all rallies begin is in bouts of short term trading activity. Look back three years and even this type of short-term tech fad was a distant hope: the difference is that it's now a reality, even if it is only emerging in brief spurts over positive earnings periods.

Tech stocks are still a mixed bag when it comes to earnings quality but this isn't what counts  when it comes to the real momentum behind large capital gains in the sector - it's the risk the equities present relative to their reward potential, and right now, that risk/return trade-off looks pretty good to most investors with a sector price-to-earnings average  in the fourties.

Is E-Bay spinning off negative PR?

WSJ columnist and writer of Loosewire Andy Wagstaff questions the number of users E-bay-owned VOIP mega-brand Skype claims to have signed up:

Internet telephony folks Skype today says that it now has 100 million registered users. A press release (free registration required) says that this was achieved in “just two-and-a-half year's time [sic], and has nearly doubled in size from September 2005 when it had 54 million registered users.” This is truly impressive. But if this is the case, where the hell is everyone?

My Skype currently shows 3,633,607 users online. Admittedly this is during the Asian day, when traffic is not as high as when the Europeans and Americans wake up. But that’s less than 4% of registered users actually online ... I can’t help wondering whether the 100 million figure is a) a wild exaggeration, down to people registering twice, b) people registering and then ditching it or c) the number of users that appears in the Skype program is just not reflecting reality.

This sounds like a classic dot-com era piece of PR hardball: not exactly fictitious, but a little misleading. Considering that, according to parent company E-Bay's website, E-Bay's total number of customers is only 181 million, the likelihood of 100 million regular Skype users certainly sounds like an exaggeration. Those figures, put in perspective, mean that more than a third of E-Bay's customer base is not from their own sui-generic brand, but from that of a recent private acquisition. If this was the case then Skype executives would surely be playing a much more prominent role in the E-Bay boardroom than they do now, and it's unlikely VOIP would have come as such an easy acquisition. Butthen  the question begs: why the need to exaggerate? Skype was an impressive purchase, is an impressive brand in a disruptive industry: why imply that 100 million people are regularly using Skype?

A quick glance at the Reuters newswire might help to explain a few things. First of all, E-Bay's just gone and spent 365 million Swedish Kroner - about $60 million - on Tradera.com, a Swedish online auction site. In other words, E-Bay, despite its enormous global customer base, is having trouble cracking the Scandinavian marketplace and needs to acquire a competitor in order to establish market entry. Then one sees that E-Bay might "increase ad spending with (a) chosen partner (such as Yahoo! or Microsoft in a collaborative effort against Google) and provide access to the data it has collected about its consumers". Translate this piece of flamboyant PR into "E-Bay wants to justify more advertising to it's shareholders" and it makes more sense. To cap it all off, however, not only is E-Bay increasing it's spending on advertising and buying new competitors because it's brand isn't strong enough to penetrate certain regional markets, but it's second quarter earnings are expected to be below analyst's expectations this year. The press release even goes as far as to cite non-GAAP (generally accepted accounting principles) figures in the statement, an inclusion that quite frankly begs disbelief  as it tells investors nothing meaningful about the financial state of the company.

E-Bay's conundrum then is how to sell what by all accounts could be quite reasonably construed as negative PR by shareholders and the market as positive signals of growth. Boasting about extensive customer bases is an obvious way to do that.

Alcatel Lucent Finalising

Scott Moritz over at the Street.com is a little unimpressed with the Alcatel Lucent deal:

The postboom era hasn't been all that fruitful for Lucent. The stock has been stuck below $5 for more than three years. And at this point, Lucent is facing a wall rather than a lot of encouraging options.

True enough, Lucent stock has not exactly flown over the past five years, but then again, neither has that of any telecoms company. And getting together in the capacity of a merger with a company whose market cap is 40% higher than your own is a pretty soft wall to face.

Capital Momentum

Capital seems to be pouring in on the management end of capital markets:

WO of London’s most successful fund management groups revealed yesterday that money from investors has been flooding in over the past year.

New Star Asset Management, a conventional asset manager founded only six years ago, announced that it attracted a net £3.74 billion of inflows last year — or more than £10 million a day.

It's the start of another boom, which I predicted a little while back.

The Boom Bust Irony

The Boston Globe suggests that realtors actually don't profit very much in a real estate boom:

It would seem obvious that being an agent during a real estate boom is a great way to earn a good living.

As it turns out, however, most agents don't make very much money during a boom, because of one simple fact: the boom attracts way too many of them.

The point summarises well the great falacy with booms of any kind: while most people to some degree feel the benefits of the increased capital surplus, booms operate a little like pyramid schemes in that only those who were in first derive any kind of substantial windfall out of it. It is a bitter twist of irony however that when the boom turns to bust, the reverse is true: even those who never had anything invested in the phenomenon at all feel the dearth of the dry-up in capital.

It's another case of the minority outweighing the majority.

Greenspan and Giuliani

Greenspan and Giuliani are fielding questions over the development of Asian capital markets this month:

As keynote speakers at the inaugural FT Asian Financial Centres Summit in Seoul, Dr Alan Greenspan, former US Federal Reserve chairman, and Rudolph Giuliani, former mayor of New York and currently chairman and CEO of Giuliani Partners LLP, will answer readers’ questions - selected by FT editors - about what criteria must be met and regulatory challenges overcome in creating world-class financial centres.

Send your questions for either Dr Greenspan or Mr Giuliani to ask@ft.com. Dr Greenspan’s answers will be published on FT.com on Wednesday April 12 at 9am GMT. Mr Giuliani’s answers will be published on FT.com on Wednesday April 12 at 12pm GMT. Both sets of questions and answers will be available at www.ft.com/financialcentres

Answers will certainly be interesting, though one can't help but feel the subject matter is a little bit of a sidetrack from the really pertinent issue, a matter both would be equally qualified to discuss: how and to what extent the United States is likely to co-operate with inevitable changes in the regulatory and financial legislature in the Far East.
 

Speculating on Movies?

So Paramount have sold their Dreamworks Library for $900 million: this doesn't look big news - just another Old Media company hitting the wall in the struggle to battle against technology - until you look at whose buying:

Paramount Pictures on Friday said it had agreed to sell its DreamWorks film library to financier George Soros' investment fund and Dune Capital Management.

Quite what quantitative macro-economic currency speculator Soros wants with Speilberg's film production company I do not know, but something is up.

M&A Action

Takeover talk hasn't been this rampant in a long time:

L'Oreal has just revealed plans to buy Body Shop for £650m and Luminar, the UK's biggest nightclub operator, has received a takeover approach from Sarcens boss Nigel Wray. There was also news from Vodafone that it plans to return £6bn to its shareholders once it has completed the sale of its troubled Japanese business.

Both sides of the atlantic, markets have been heating up with buy-out talks. While this is rarely a good thing for the companies in the M&A process - most large-scale mergers and acquisitions, after all, are notoriously difficult to configure in terms of profitable value until a long time after - it bodes fantastically well for equity markets as a whole.

Round Two of The Macro Game?

From CNN:

The Senate voted Thursday to allow the national debt to swell to nearly $9 trillion, preventing a first-ever default on U.S. Treasury notes.

The bill passed by a 52-48 vote. The increase to $9 trillion represents about $30,000 for every man, woman and child in the United States. The bill now goes to President Bush for his signature.

...The debt limit will increase by $781 billion. It's the fourth such move -- increasing the debt limit by a total of $3 trillion -- since Bush took office five years ago.

The vote came a day after Treasury Secretary John Snow warned lawmakers that action was "critical to provide certainty to financial markets that the integrity of the obligations of the United States will not be compromised."

Several things always seem to follow increases in the U.S. deficit. First of all, everyone speculates that the United States will no longer be the great global superpower it once was for very much longer, and that this is a sure sign that some "emerging economy" is going to take over instead. Money then floods into these emerging market economies in the desperate attempt to find the next goldrush, as the investors mistakenly see their capital as "investment" rather than "leverage" propping up largely unsustainable growth. All the capital from this growth is stored, naturally, in  U.S. T-Bills. Emerging economies then open derivates markets to all possible national financial instruments: stocks, commodities, even their own currency, in order to provide further liquidity for all this capital "investment".  At the realisation that all this "growth" is not going to materialise, investors quickly divest all their savings, which usually do not amount to much, as a few savvy macro Hedge Fund managers cash in enormous futures contracts against the local currencies (enabled by the recent opening of the derivatives markets), ending up as the only ones to have made anything near the promised billions in profits.

THEN comes retaliation time: U.S. politicians negotiate large financing pckages usually disguised  with creative names like "hybrid loan payments" to "help" these poor countries,  which in turn helps finance their own large deficit (remember, of course, that reserves - cold cash - are stored in U.S. government bonds anyway). Capital pours back into U.S. markets, so dollar-denominated commodities such as oil come off in price: subsequently there is a giantic swell in equity prices, and all looks good until they explode again.

Rinse and Repeat, over and over and over again. Compare today's situation with the scenario just over ten years ago, and China looks like Japan and Thailand used to. With the recent opening of their derivitives markets, and the loosening of investment in equity, real estate and the Yuan, another round of boom bust cycles does not look so unlikely.

Economic Miscalculations & Ramifications

Tom Peters picked up recently on a great article which appeared in Business Week claiming that the economy is not actually as poor as pessimistic economists woud have you believe:

"Business investment in intangibles such as product development and training is critical for long-term profitability, but it doesn't get counted in GDP." The unreported annual sum was most recently $978 billion, almost as much as the reported investment in physical capital. Re-calculate, and "investment as a share of the economy is rising rather than falling."

Household outlays for education, the most important investment in the future of the next generation, are improperly counted as consumption." Re-calculate, adding in this uncounted $224B, and "personal savings were positive, not negative."

This is just one way in which outdated calculation methods are giving misleading signs about the health of economy in perspective of the new architecture of the "Knowledge Economy".

What is more worrying however is how much we may be miscalculating the growth rates of countries such as China and India, however. Look again at the above examples: how much investment in training, product development, and education can one reasonably posit is taking place in these economies as opposed to the gross investment in real estate, developing traditonal business "value chain" partnerships etc.? Seen like that it looks like we may have hugely overstated the imminence of the Far East's economic supremacy, as well as misunderestimated the U.S.'s.

Asia Analysis

Leo Lewis of The Times today on Japanese media deregulation:

""84% support standard prices for newspapers" bellowed the front page of a major Japanese newspaper yesterday, before plunging triumphantly into a drawn-out explanation of why monopolies are so important.

"You see, there are some who might think that Japanese newspapers should take their fourth estatey duties seriously.This is, after all, a country where special interest groups, crime syndicates, poorly regulated businesses and authority-ravenous bureacrats have a somewhat chequered relationship with unchecked power and could often do with the odd word of criticism from the ladies and gentlemen of the press."

Such observations could hardly have come at a more prescient time. Had the media in Japan been a little more scrupulous about the hard facts in the 1990's, instead of towing the national line and pandering to the egos of Chief Executives, perhaps it might have unearthed some of the dubious accounting methods their organisations were employing rather earlier on and prevented the economic debacle from which the country is only just beginning to recover.

One of the central issues with development of the Asian economies is that the culture - unlike the United States or Europe - does not encourage criticism of its superiors, which tends to lead to an inefficient regulatory and auditing process: even when such measures are required by law, in practice they are often half-hearted. This is one argument for the centralisation of Beijing's power that few in the western world fully understand: when officials are sent from the highest possible post to regulate ethical practice, the extent of the government's authority often gives such officials the incentive to dig properly into the areas where they would never do so otherwise. Take away the centralisation of power, and corporate CEO's tend to get pretty much what they want, how they want it. This is exactly what happened to Japan in the last decade after she embraced American culture so whole-heartedly in the 1980's.

The challenge now the Far Eastern economy is booming again is to keep this essential centralisation of power in tact whilest supporting competitive anti-trust practices. To do that, governments need to start thinking like economists, and not just as politicians.

Disingenious Analysis

Laura Rich, Editorial Director of the American business monthly Inc. displays some considerable naivety about the functions of capital markets in an article she wrote about the decline in the number of IPO’s last week, belligerently titled “No possibility of an IPO? Who cares. (sic)”

“A story in the Wall Street Journal today makes a big stink over the steadily dwindling number of initial public offerings by start-up companies” wrote the New York Times columnist on Inc.’s weblog, Fresh Inc. “The numbers are indeed bleak: 2005 saw 41 IPOs by venture-backed start-ups, compared to 67 in 2004 and a booming 250 in 1999, according to data from VentureOne, which tracks that sort of thing … The point is, it's hard to see that things are, really, all that bleak for start-up companies. These days, the money's just not in the public market -- it's the private market where it's all happening.”

It is difficult to believe that qualified business journalists would actually put their names to this kind of crude amateur analysis, for it shows a serious flaw in the comprehension of how private and public capital functions actually work. In the first place, any comparisons between 1999 and today are almost universally set aside by professional analysts today as the bull market of the millennium is hardly a fair benchmark for meaningful quantitive data. Secondly, to suggest that there is no difference whether money remains in private equity or heads towards publicly tradable markets displays a gross misunderstanding of the most basic level macroeconomics.

“Who cares?”

Rich asks her readers rhetorically, “So, sure. The IPO market is not what it was for start-ups. But who really cares? Do you?” Well, for one, I’m sure the U.S. Federal Reserve has more than a passing interest in the performance of the IPO market, as it effects the inflow of fresh capital and companies to the NYSE and the NASDAQ, which in turn effects the prices of government bonds and the parameters for rates at which the government can afford to lend and borrow money, and with the current highs of the national deficit, oil prices and the recent ruminations from Beijing that China will now start to cash-in some of her reserves currently held in U.S. T-Bills in favour of international diversification, the establishment of reliable cash flow channels is hardly a done deal right now.

Then there are the numerous retail brokers such as Charles Schwab and their clients, the private investors, who make up a sizeable proportion of the capital markets. While institutional investors such as venture capital funds benefit from private equity placements, private individuals generally only gain significant exposure to these investment opportunities once they are listed as equities on a stock exchange – indeed, this in one of the key functions of an exchange: that it allows a larger pool of individuals who otherwise cannot gain access to investment opportunities to take part in the shareholding process.

In addition, it is retail investors who often facilitate much faster capital market cash-flow as they create easily-available, liquid secondary and tertiary markets for the sale of equity that institutions have realised a capital gain on: this has the effect of freeing up capital that venture capital funds use to finance further investors.

Here the columnist and Editor really might have thought harder about her postulation. To suggest, as Rich does, that “more entrepreneurs are finding it a seller's market,” and that “(they) are doing just fine” is to naïvely assume that only a primary market is necessary in order to facilitate entrepreneurial and innovative growth in an economy. The principle goes back to the age-old law of supply and demand: if demand at the lowest level does not outstrip supply then capital dries up – in the same way, if there is no “re-sell” IPO market for private equity investments then continued funding of entrepreneurial ventures cannot foreseeabley be sustained. Corporate financing activities such as industry trade purchases and big company mergers, as stated as one of the reasons for the IPO decline by The Wall Street Journal in Rich’ s riposte, is hardly a reliable long-term strategy for continued investment funding as there is a significant limit the possibility of these types of deals without fresh capital to cushion the activity.

And so it seems that despite the fact that Rich and her erstwhile team of amateur economists at Inc might not care that much for the number of IPO’s in the market, the very entrepreneurs who she directs so enthusiastically to the publication’s valuation guide – “Take a look at our Ultimate Valuation Guide to get a sense of all the companies that are cashing in” – might end up caring rather more than it seems.

Blowing Hard, Blowing Fast

It’s difficult to see how anyone could be pessimistic in this economy: with consistently low interest rates, a significant increase in big company mergers and acquisitions, growth in the Far East of exponential proportions, and an all-time high in Wall Street and London financial city bonuses, the economy and the markets set look to rock and roll in 2006 – and yet there are still plenty of dissenters. It makes me think that where trouble lurks is in analysts’ and traders’ underestimation about just how large the next bubble is being blown up right now.

Most of the economy naysayers point to inflated oil prices and the unresponsiveness of global equity markets to the impact of artificial ‘tweaking’ designed to get them going again in support of their bearish views, but the examples miss a greater extent of detail in thinking about macroeconomic boom-bust cycles.

When former Chairman of the Federal Reserve Alan Greenspan lowered interest rates dramatically after the market crash of the early turn of the millennium, most were expecting this to have the same designated effect it had had on past markets: namely, to give them a quick shove in the upward direction. When this didn’t happen, people started claiming that the midas financier had lost his touch, but the criticism missed the point. Gone was a market environment where there was plenty of free capital waiting to be released at the right place at the right time: even if equity prices look cheap, if there’s no capital sitting on deposit accounts and in government bonds waiting to pounce on the opportunity of higher investment returns, then artificial processes of bolstering markets are redundant. Having been hit with substantial blue-chip bankruptcies and more than a sixty percent fall in equity prices, it wasn’t just that the U.S. economy was in a dispiriting mood for capital investment, it was that there was very little to go around in the first place.

As is the case with post-scenarios in all market crashes, what capital markets needed was time for the swell of money to accumulate outside the market, and to do that, the right environment had to be present for a sustained period of time. And by all accounts, the environment for capital accumulation couldn’t have been any better than it has been over the last five years. Interest rates have remained consistently low, as reflected in real estate prices. Investment in emerging market economies such as China and India has swelled to an all-time high: not only in the form of direct investment, but this time in the form of corporate cost-saving concepts such as outsourcing.

Add to this that oil prices have been pushing significant highs, for contrary to popular scepticism, periods of high oil prices can be considerable long-term market drivers. For one, just as with any pricing mechanism, what goes up inevitably comes down. The significant uptake in demand from development of emerging market economies such as China and tension in the Middle East has created an over-pricing reaction of oil to above $70 a barrel, but once the global economy has adjusted to this new supply-demand ratio prices will begin ease. And when they do, organisations will find they have more capital than they thought to play with, for the net effect of high oil prices is to force companies to become more prurient with their capital, and cut costs in unnecessary areas that they are only too happy to blow on in times of excess – when the pressure begins to ease, companies accustomed to budgeting for these aberrations feel it first, and the excess capital is felt throughout the market. In addition to this, sustained periods of high oil prices as we have experienced them actually benefit exploration into cheaper technological methodologies of energy usage hugely, as both corporate and government budgets are incentivised towards investment in what otherwise appears like tomorrow’s problem. The irony is that it is in periods of short-term cost-inflations that effective long-term cost-cutting strategies are formulated.

Consider too that there is almost a disdainful belief in another equity boom by some camps. Bull markets are, in a similarly ironic twist, propelled by those of bearish attitudes. It is those that do not buy into the first, second and third rounds of asset price inflation who end up buying in at the fourth rounds, further propelling the bubble to new dizzying heights – in this way, bull markets feed off bearish counterparts, or there would just be one sharp upwards and downward spike in prices – and there are still plenty of bearish speculators to go around to make the next explosion in equity prices all the more viable.

If one looks at the market climate of the early/mid-nineties, and that of today, there are some startling similarities – a post-war Middle Eastern crisis, a booming Asian economy (before the sudden downturn in 1997), post-stock-market-crash bearishness with no shortage of innovation. All are back in vogue, with one key addition: they are more extreme than a decade ago.

Looking at all the indicators, another bubble in tech equity prices seems inevitable, at even more extreme measures. Market regulators ought not to be worried about whether equity prices are going to pick up again, but about how to handle the scenario when they do, for if it takes them by surprise, it may well be more than they are equipped to manage.

Good News For China

The floatation of China Construction Bank (CCB) at the end of last month is good news. Despite the enormous market capitalization of $66 billion (which makes it larger than Barclays, American Express and Deutsche Bank) based on perhaps less than reliable indicators, it is a step in the right direction when countries allow national banks to become public.

The scepticism expressed by some about the value of the investments CCB receive as collateral for lending should be eased by the other scenario: that CCB remains private and thus does not need to be accountable to a large pool of public shareholders about its internal valuations and projections. Because the money trails of most investments lead back to banks in one way or another – especially in the case of the CCB – they are usually pretty good indicators of the genuine performance of market as a whole, helping to give some good performance indicators. This has been evident in developed countries for many years - when the good times start rolling, banks are usually the first to feel the impact; conversely, when the going gets tough, banks tend to catch cold more quickly than some of the more elastic industries.

Part of the problem with investing in China before now was the lack of a large public financial organization. Because of the lack of any financial regulatory or reporting systems in China in the 90’s, it made it very hard for foreign investors to gage the valuations of the market as a whole – even in the case of traditional manufacturing industries investors paid way over.

As hard as Liu Mingkang, head of the China Banking Regulator (CBRC) tries, real-time reporting is often the best indicator of economic performance. CCB going public means it will be harder for companies within China to fudge valuations as the bank is forced to become more reliable with its reporting figures. This can only mean for a more accurate and efficient market. The long-term viability if investment China depends on more than the current round of sales hype.

There may be some teething troubles as industry in China adjusts to this new step-up in reporting efficiency, but the long term benefits will be felt with a higher degree of confidence in China as a whole, which should bring transparency and liquidity to shadier areas of the market. This is exactly what happened in Thailand a decade ago, and helped massively in swiftening the recovery of the economy after the currency debacle in 1997 as the world banks and economies were able to offer viable solutions to the hybrid loans weighing down on cashflow. The more investors can see, the more willing they are to participate, whatever the scenario.

OFEX musings

“Know your customer” has to be the oldest rule in the book. Who buys your product? What are the reasons your customers buy your products? And how do you make them keep coming back? Twenty-five years ago, the now infamous management consultant Tom Peters co-authored the revolutionary bestseller In Search of Excellence, in which these were the very focus of his criticism of big companies in the United States. In this magnus opus, Peters’ number two “rule” was Staying close to the customer.

One thinks on the face of it that perhaps Simon Brickles might be tempted to pick up a copy of In Search of Excellence. When one considers the all-too-often overlooked fact that Ofex was launched in the same year that the Alternative Investment Market was formed, the discrepancy between the two markets is startling. Admittedly the bulk of Ofex’s evolution has absolutely nothing to do with Mr. Brickles, who only joined to head up the flailing market late last year, but one does have to consider why AIM seemed to get it right and Ofex, by comparison, has seemed to get it so badly wrong, in exactly the same timeframe.

And contrary to popular investor opinion, the answer does not entirely lie with J P Jenkins. In fact, under J P Jenkins’ guidance, the market has experienced some of its best years, and although this has more to do with the macro-economic “tech hype” of the late twentieth century, this still has to be considered in relation to the dismal passing of its predecessor, the Unlisted Securities Market, which failed even in the bull market of the 1980’s to make any relevant kind of impact. The big question is: why are the majority of investors still looking for an AIM listing as an ultimate exit strategy, and is this sentiment justified? And, if justified, what are Ofex to do to reverse this sentiment?

            

Unfortunately, this is where the argument becomes somewhat complex, and is hopefully one which the chiefs at PLUS Markets are asking themselves right now (if not, they certainly should be!) Yes and No, is the answer. Investor apathy towards Ofex stems from, by and large, one very prescient concern: liquidity. And this is precisely the concern that Mr. Brickles has been attempting to address since his appointment to the helm of Ofex. And his track record speaks for itself: as one of the key founders of the Alternative Investment Market, he succeeded beyond all expectations (especially considering that at the time, the UK had yet ever to establish a small company market with any kind of real regular market size) in creating the first UK small cap “trading” environment. By proactively approaching potential market makers to get involved with Ofex, by increasing the public prominence of the listings through simple old-fashioned relationship building with the City Corporate Finance houses, Brickles has made a great start. But the problem remains for many investors: Ofex is still illiquid.

In an obvious sense, the investors are justified: the only real reason one makes an investment in the first place is to realise a capital gain, and a gain cannot be realised in a marketplace where there is no demand for the investment. But more astute investors have been picking up on this dearth of interest through the lack of liquidity lately, and seeing there is more than one way to make a capital gain other than in selling shares in the “open market”. As the Private Equity market has begun to swell, Ofex has increasingly begun to look to some like a bargain basement for undervalued private equity companies, where due to the short term whims of irrational investor psychology there are, literally, twenty pound notes lying around waiting to be picked up. Take Vicorp, a recent issue from St. Helen’s Capital. With the prospective sales pipeline and what looks like a steal on future revenue, the company for many investors represented a steal in the early hundreds.

            

So Ofex now has another headache on its hands. Is it a “platform” for private equity opportunities or is it attempting to become a “speculative” traders’ marketplace, where the day-trader will ultimately be able to buy and sell with no fear of sitting on an unrealisable asset, no matter what the theoretical capital gain?