Look east, young man…

In trying to read the economic Tarot cards, most are focused on the U.S. and Europe.

At first glance, this is quite understandable. The European economy is the largest in the world, followed closely by the U.S. But, that’s not where the action is.

Indeed, the world economy increasingly turns on the axis of #3: China.

If you want to know where things are going, look east.

I say this for two reasons: 1) markets have been increasingly led by action in China, and 2) fundamental economic reality is being driven most by China.

When the economies and stock markets of the world turned positive in 2008 and 2009, it happened first in China.

All other markets are reacting to what happens in China, too. When China hints they may let the renmimbi appreciate, markets shout “how high?” When China hints its trying to subdue real estate speculation, markets shutter the world over.

The simple fact of the matter is markets are reacting increasingly to news from China.

You may think of markets as being speculatively fueled, but a look at underlying economic reality provides a basis for these flighty reactions.

China is the world’s third largest economy, passing Japan within the last two years.

The Chinese economy is–by far–the fastest growing large economy.

China became the world’s largest export economy, passing the former #1, Germany, just last year.

Demand from China is driving the markets for the most basic inputs to production. Watch the price of shipping, iron ore, copper, steel, oil, or almost anything else, and you’ll most likely find news from China caused prices to jump or dive.

China has become the manufacturer to the world. You can’t consume what hasn’t been produced, so China is holding the economic cards, now. If you don’t believe it, watch Chinese workers striking Honda or demanding hiring wages from purchasers like Apple and Hewlett Packard. This wasn’t happening a year ago because China didn’t hold the cards. They do right now.

Finally, China’s economy is the only large economy whose government isn’t in a fiscal straight jacket. The U.S., Europe and Japan are all hand-cuffed by borrowing and spending too much. China’s government is almost certainly making uneconomic investments, but they have the ability to invest whereas the other large economies’ governments are out of ammunition (or soon will be).

If you want to know where things are going economically, look east.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Dumbfounded

It first started to occur to me around 5 years ago that the housing market would probably crash and that it would almost certainly drag credit markets down with it along with home builders, mortgage insurers, bond insurers and several financial institutions.

But, if you had asked me 5 years ago what the Dow Jones Industrial Average (DJIA) would trade at given that:

1) 3 of the top 5 investment banks in the US would no longer be independent and the final 2 would be tottering
2) the US government would take over Fannie Mae and Freddie Mac because they were insolvent
3) the US government would own 80% of AIG’s equity because it was also insolvent

I would have said the DJIA would be at $5,000, not $11,388.

What color is the sky in most investors’ world? Does anyone really believe all these bailouts will be cost free?

I’m dumbfounded.

Don’t get me wrong, my investors and I are doing very well both absolutely and relatively to the market.

But, isn’t the US economy entering what could be the worst recession since the early 1980’s? Isn’t government intervention on a scale not seen since the Great Depression an indication of how bad things are? Isn’t the world economy entering the first widespread slowdown in a generation?

Then, why is the market down so little?

I have no idea. In fact, I’m dumbfounded.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

If the economy is limping along okay, then why are FedEx and UPS down so much?

It’s always interesting to watch reports about the broader economy and compare them to what’s happening to large corporations, like FedEx and UPS, that may more clearly indicate what’s really going on in the U.S. economy.

This week, people claiming unemployment insurance declined. Also, leading economic indicators were up for the second month in a row. Perhaps things aren’t so bad?

But, at the same time, FedEx reported its first quarterly loss in 11 years and reduced expectations going forward.

The stock of FedEx is down over 20% during the last year. UPS is down around 10%.

How can the economy seem to be motoring along when companies like UPS and FedEx seem to be doing poorly?

When given the choice between economic statistics (that get revised over and over again, and are heavily dependent on many shaky assumptions) and the performance of large corporations, I’ll take the performance of large corporations any day.

I think UPS and FedEx are indicating what’s happening in the economy better than broad economic statistics, and it isn’t pretty. Growth is slowing or declining, and you can see it in the volume and profits of the shippers.

In time, economic statistics will reflect this. In the meantime, I’m watching the major companies and what they’re saying is happening instead of focusing on the economists.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Perhaps the Fed should include food and energy prices in inflation?

Since the late 90’s, oil prices have rocketed over 1000%. Riots are occurring around the world because of shortages of such staples as rice and wheat. Even Costco and Sam’s Club are rationing rice consumption here in the U.S.!

If the cost of such fundamental necessities as food and energy are going up so much, why do economists and the Fed believe that inflation is stable and at acceptable levels?

Quite simply, they don’t include food and energy prices in their calculation of “core” inflation (that sounds like the same game as reporting “operating” and “pro forma” earnings that companies were criticized for 8 years ago).

You see, food and energy prices are very volatile, and most of the time their movements make inflation look uncomfortably unstable.

But, what happens if food and energy prices are rising because of real, no kidding inflation? The Fed and most economists have no way to adjust for this. Don’t be surprised, though, if they finally get around to adjusting long after we’ve all been beaten down by “non-core” inflation.

I’m no economist, but I think I understand what makes for a stable currency.

The central banks of the world run the printing presses, and they can print dollars (euros, yen, bahts, pesos, reals, etc.) at almost no cost. This doesn’t create value, mind you. What it creates, when dollars are printed faster than underlying growth, is inflation.

In my humble opinion, that’s what we’ve been experiencing at a faster and faster pace over the last 10 years.

The central banks of the world reacted to the Asian contagion by printing more money. Then, they reacted to the fall of Long Term Capital Management with more money printing. Y2k (remember that “crisis”?), more money printing. Telecom, technology and dot-bomb crash, print more money. Housing crash and credit crisis…you get the idea.

I don’t think energy and food prices are running up temporarily, I think this is the slow bubbling up of inflation created by the world’s central banks over the last 10 years. You can see it bubbling up through the economy from energy to metals to transportation to food.

The easiest place to see this is in the price of gold, which bottomed at around $250 and ounce in the late 90’s and is now 360% higher (after peaking 400% higher). Or, look at shipping rates. Or, look at base metals prices. Or, look at iron ore and coke used in making steel. Or, look at wheat, rice, etc. Do you suppose chicken, beef and pork could be next?

Think what you’d like about government bailouts and stable currency, I believe we’re getting more and more inflation.

Could this all be the result of higher demand, especially from China and India? In the short term, yes. In the long term, no. That’s where the rubber meets the road from a forecasting standpoint. If demand is the cause, then profits and innovation will eventually drag prices back down, as most economists are betting will happen. But, if part or all of the price rise is due to inflation, then expect prices in general to stay higher.

How long before central banks and economists start adjusting inflation for food and energy costs? Don’t hold your breath.

I’m expecting prices to go up long term, even if they take a breather as the U.S. and global economies slow down. In time, though, we’ll all have to recognize that prices are probably permanently higher, and the it’s the result of inflation caused by our central banks. When people start to more generally recognize this, higher interest rates will be another thing to deal with.

Investing in such an environment can be difficult, but also very profitable. I’m glad I prepared myself and my clients for just such a possibility years ago.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

If the US economy slows, will the world economy slow, too?

Many market watchers believe that even if the US economy slows (as it looks like its doing), the global economy will stay in the growth lane because emerging markets like China, India, Brazil and Russia will more than make up for US slowing.

A look at historical information and the global yield curve seems to contradict this. William Hester, CFA of Hussman Funds wrote a great article addressing this subject.

The global yield curve is a way of looking at the yield offered by government bonds around the world at different maturities. By comparing short to long term bond yields, one accesses one of the most reliable predictors of economic growth.

You see, when short term rates are equal to or higher than long rates, this almost always signals economic slowing and, usually, a recession. When short rates are equal to long rates, that’s referred to as a flat yield curve. When short rates are higher than long rates, that’s called an inverted yield curve.

Using global bond yields, as Hester does, a flat or inverted yield curve usually precedes a recession by a year or two. As he shows, the global yield curve turned flat last July, perhaps signaling that global earnings growth may slow, too.

Although the yield curve is not a fool-proof method of determining future economic growth, it’s been reliable enough that it shouldn’t be ignored, either.

Although it looks like the world economy is currently humming right along and will easily weather the US slowdown, the yield curve is telling a different story.

As Hester suggest, this has historically been a bad time to be in industrial, consumer discretionary or energy stocks, and a good time to be in materials and consumer staple stocks.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Dow 13,333

Amazingly enough, the market just keeps hitting new highs.

Despite headwinds from a slowing economy, higher gas prices, and a rocky housing market, most companies beat analysts estimates for the quarter.

The world economy is thriving with good (for them) growth rates in Europe and very high growth in China and India.

U.S. companies benefited this quarter, too, partially because they sell many goods and services to other countries and partially because the declining dollar provided an additional tailwind to results.

Another benefit, which the analysts seemed to have missed, came from companies buying back their own stock. If a company’s earnings increase by 5% and it buys back 5% of its stock, it suddenly has 10.5% growth in earnings per share. No real magic there.

I’m not foolish enough to try to forecast the short term direction of the market, but I do have some questions about how these dynamics will affect markets in the future.

If the Chinese economy slows, as the government there is trying to make happen, how will that impact the world economy? How much further can the dollar decline before it leads to increases in U.S. interest rates? How could U.S. companies be impacted by a slower world economy and higher U.S. interest rates? How much longer can companies buy back their shares instead of investing in new projects, capital expenditures or wages and salaries?

I don’t claim to know the answer to any of these questions, nor do I believe that answers to these questions are necessary to successfully invest over the long term. But, I do think it is important to assess the substance behind the recent good news and ask myself whether such tailwinds are likely to continue going forward.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.