Tuesday, 9 June 2009

More Sense In One Issue Than A Month of CNBC
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Tuesday, June 9, 2009

  • People have come to think the stock market bounce is permanent...
  • Consumer behavior has changed - and so have consumer goods...
  • We know where the dumb money is...but where's the smart money?
  • Ajit Dayal on why investors abandoned the Indian market...and more!

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    Two Ways to Deleverage an Economy
    by Bill Bonner
    London, England


    The dumb money is fairly easy to spot. It's the money that always shows up late to the party, wearing yesterday's fashions. It watches TV and thinks the reality shows show reality...it thinks Ben Bernanke is a great economist...that the SEC protects investors from fraud and misrepresentation...and that Tim Geithner makes sure the economy keeps running smoothly.

    It's the dumb money that thinks you can correct a generation-long period of credit growth in 24 months...with less than 10% unemployment...

    Stocks have now been in a rally for three months. The longer this goes on, of course, the dumber money gets. People come to think the bounce is a permanent bull market.

    Yesterday, not much happened. Stocks held steady. Oil too. Gold fell $8...closing at $952. And the dollar rose to $1.39 per euro.

    But while the dumb money has its eyes on the stock market, the smart money is watching the economy.

    Unemployment has risen to 9.4 million in the United States. Experts think the rate of job losses is slowing. But month after month, more and more people are not collecting wages. Instead, they're coming to rely on handouts from the government. The press reports that one in every six Americans is now on some form of government life-support. (More on that...tomorrow...)

    Same thing in the housing sector. Robert Shiller says the housing slump has already knocked prices down 32%...and has a long way to go. This alone guarantees a long period of adjustment. Bad decisions - usually those with huge debt bombs attached - will blow up...then they need to be cleaned up...and then, after the destruction, comes the constructive rebuilding. All that takes time...years.

    People whose houses are going down in price...and whose incomes are falling...do not buy more stuff. Sales go down...profits go down...and dividends go down. Why would investors buy stocks when earnings and dividends are falling? Good question. Pull your shorts up, dear reader...pull your shorts up.

    House prices are still going down - but not as fast. Still, big resets, defaults and foreclosures are still on the way - in prime and Alt-A mortgages. But there is still time to protect yourself from this second wave of defaults. Get all the information you need in this special report.

    Meanwhile, when companies don't sell...they don't ship either.

    The trucking industry says traffic is off 13% from a year before - the biggest drop in 13 years.

    Airplanes are carrying 21% less cargo. And the commercial airline industry says it is losing $9 billion this year.

    As for shipping...well, don't even bring it up. Shipping has been in a catastrophic slump since last year - with cargo rates down 90%.

    Obvious conclusion:

    "Every smart trader I know is massively short the stock market," says Jeff Clark.

    You should be short the stock market too...or look to the 'anti-stock market'. This market can never go bust...and it doesn't care about earnings reports, clever accounting, analysts' upgrades or downgrades. But the best part of this 'anti-stock market' is the virtually unlimited profits. In fact, the nastier the stock market gets, the more money readers have the chance to make in the Anti-Stock Market. Just ask the readers who've already seen 85%, 72%, 67%, 100% and 80% gains so far in 2009.

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    More news from Ian at The 5 Min. Forecast:

    "The national average gallon of the cheap stuff has risen 41 days in a row, to $2.62," writes Ian in today's issue of The 5 Min. Forecast.

    "That's a $1 rise, or 61%, from the average gas price at the start of 2009. Certainly enough to scuff the luster off those economic 'glimmers of hope,' don't you think?"

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    "'This hits everyone,' famous Yale economist Robert J. Shiller told the NYT. 'It has the potential to affect your confidence.' According to Shiller, a few months at these prices could offset President Obama's new $400-800 middle class tax cut. The Oil Price Information Service claims today's gas prices costs consumers $400 million more every day compared with January's ultra low prices.

    "Will it go higher from here? If oil's price is any indicator, maybe. While gas prices are up 61% from their lows, crude oil has more than doubled.

    "'Consumer behavior has changed,' adds Dan Amoss. 'The typical basket of consumer goods is also changing. Most consumers are smart and adaptive and realize they need to save a lot more out of their paychecks, and will do so despite the government currently encouraging as much spending and risk taking as possible. This trend will last for years, and we should not underestimate it.

    "'Consumers will still spend more wisely on things that provide good value, and on affordable luxuries like gasoline (the talking heads still underestimate how strong gasoline demand will remain throughout this recession). Yes, I consider gasoline a luxury, and more probably will as the rest of the developing world increases gasoline consumption - recession or not. Governments are printing money and running deficits, and as long as this is happening, this new money will chase goods that every human demands - like refined oil products.'"

    Don't miss Dan's presentation at this year's Agora Financial Investment Symposium in Vancouver, British Columbia. All of the Agora Financial contributors will be there, along with a few special guests. To check out this year's line-up - and to secure your spot - see here:

    Agora Financial Investment Symposium, July 21-24

    And more thoughts:

    The blogs are chattering about poor Lee Mozilo. He's no Angelo, they say. The SEC claims he told investors that all was well in his company, Countrywide, while he was dumping shares.

    We don't know the details, so we wouldn't rush to judgment. But our guess is that the SEC is trying to recover its reputation by putting on a few show trials. The SEC has a pack of watchdogs on the payroll. But somehow thieves stole every decent part in the junkyard without a single one of these mutts bothering to bark. Now, they're indignant...and out for justice!

    Did Mozilo do something wrong? We don't know. But the question would never have come up if it hadn't been for the crisis in housing debt. As long as housing was going up, everyone was happy with Countrywide's business model. Yet didn't everyone know that the mortgage finance business was a dangerous place to be at the end of a housing bubble? Didn't the SEC know it, too? If we recall correctly, Mozilo said so himself...

    But the SEC watchdogs slept through the biggest heist in history. And now the people who lost face and lost fortunes are eager to pin the blame on someone other than themselves.

    But that's just part of the whole process of deleveraging. That's how capitalism works. People lose money...then they lose jobs...and houses...and businesses go into chapter 11 and a few of their CEOs go to jail.

    All that takes time. And betting against deleveraging is probably not a smart thing to do. Not until it's over...which is not until the leverage built up in the bubble era has been removed. And with total debt levels at 370% of GDP...and the government adding even more debt...we're a long way from there.

    But what do you do, dear reader? Buy Treasuries in anticipation of another crash in stocks? Or mortgage your house, long-term fixed-rate, in anticipation of fed-caused inflation?

    Ah, there's the tough question. We know where the dumb money is...but where's the smart money? Jeff Clark says it's short stocks. But there's some very smart money that is betting that the government will turn this around. They're putting their money on inflation...or even hyperinflation. Our old friend, Marc Faber, for example, says he is sure the United States is headed for hyperinflation. If so, shorting stocks may not be such a shrewd move. Stocks could soar too - as investors try to buy anything and everything that didn't have dollar signs on it.

    You see, there are two ways to deleverage an economy.

    The obvious way is the traditional, honest way - in which people actually try to pay their debts. This causes the problems we see as falling asset prices, bankruptcies, joblessness and the other hallmarks of a Great Depression.

    But the feds have their hearts set on preventing a depression. And they're doing it the only way they can...by the old 'hair of the dog' technique. The economy suffers from too much debt - so they're going to give it more! Much more. The whole pooch! The whole kennel! Then, they round up every stray mongrel in town. What happens when they run out of dogs? Well...that's a discussion for another day.

    We have had many laughs following the feds and their war against capitalism. They're gambling an amount nearly equal to the entire U.S. GDP to try to prevent people from getting what they have coming. In the process, they're almost certain to make a mess of things.

    The smart money is betting that they fail to stop deleveraging. But the very smart money is betting that they create a new, worse problem - inflation, maybe hyper-inflation. Inflation reduces the real value of debt...but in a perverse and unpredictable way. Debtors don't pay their bills; savers pay them. Inflation - like bailouts - rewards the least responsible players...those who have gotten themselves heavily in debt...and punishes those who have done the 'right' thing. As Germany saw in the '20s, it de-stabilizes the whole society...leading to extremely unwelcome outcomes.

    Until tomorrow,

    Bill Bonner
    The Daily Reckoning

    P.S. And you know where the smart money turns in time of inflation: gold. Gold has always been the ultimate hedge against inflation. Avoid the rush - pad your portfolio with this precious metal now. See how here.

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    The Daily Reckoning PRESENTS: If you had swine flu in China, the authorities would catch you. In India, the swine flu itself would catch you. But the essay, below, is not about swine flu - but about investors that flew out of the Indian stock markets in the year 2008. Ajit Dayal explores...read on...


    The Swine Flew
    by Ajit Dayal
    Mumbai, India


    When you land in China, they send two teams of medical crew wearing spotless white attire from head to toe, looking a bit like astronauts heading towards the rocket for a lift-off.

    The silent crew parades the aisles, examine your eyes and flash a beam on your forehead to check your temperature. They are looking for symptoms of swine flu.

    Only after every passenger has been checked and approved, they allow the pilot to move the plane to the parking gate and offload the passengers.

    You land in India and are back to Indian-ness: passengers coming down two escalators and one flight of stairs quickly fill a makeshift queuing system. Within minutes, the continuous stream of people coming down the escalators can no longer get off - the space ahead of them is a stationary wall of people. A lady on crutches falls - the escalator blades disappear from under her feet and she has nowhere to stand.

    There is chaos. The airport staff looked on - and did nothing.

    I alert them. "We will tell the management," they respond.

    Once you get to the people behind the desk with your medical form, they stamp it - without even looking up. You then proceed to immigration and you are cleared to officially enter India.

    If you had swine flu, the Chinese would catch you. In India, the swine flu would catch you.

    China, said a friend, has learned from its mistakes.

    He was referring to the SARS epidemic that reached frenzy in March 2003. When the medical team from the World Health Organization landed in China to inspect the patients, the hospital administrators bundled all the affected SARS patients in ambulances and made them circle the city.

    The WHO inspectors found nothing in the hospitals.

    China got a clean chit.

    But the Chinese ended up living through the horror of SARS.

    Do you think, my friend continued, it is a coincidence that WHO is the only international body that is now run by a Chinese person? China really wanted its nominee as head of WHO - Dr. Margaret Chan. And, within China, there are only two ministries that are run by people who are not from the Communist Party: the Ministry of Health and the Ministry of Science & Technology.

    Having made a mistake, the Chinese gulp a bit - and then go on to ensure it does not happen. So going forward China will have fewer cases of swine flu, I guess.

    India will have more cases of people's clothes, shoes, and limbs stuck in escalators as they queue up to go through the motions of a useless medical "examination".

    But no, this is not about swine flu - but about investors that flew out of the Indian stock markets in the year 2008.

    The Participatory Note, or "P-Note" investors - the sub-set of foreign institutional investors (FIIs) who have caused havoc in the Indian stock markets on the way up in the year 2006 and 2007 - and on the way down in the year 2008.

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    These flows (Table 1 above) represent the total net foreign money entering the stock market. On average, the foreign money flows are 4 times those of the money flows from the domestic mutual funds.

    However, we don't know what percentage of this foreign money flow belongs to P-Notes. The P-Notes are a strange animal in the Indian capital markets.

    As an Indian, if you want to buy shares, the government wants to know everything about you. As an Indian, if you wish to buy a mutual fund, the government wants to know everything about you.

    If you are a U.S., European, or Japanese pension fund, university endowment, or charitable foundation, then the government also wants to know a lot about you.

    But if you are a P-Note holder, heck no one cares at all about who you are!

    Foreign investors who have a long term interest in investing in India - and by "long term," I mean a minimum 5 year time horizon (if not twenty and thirty year time horizon) have not yet come into the Indian stock markets in a big way.

    I know this because some of them are my clients.

    And I meet many of these long-term investors many times in a year. The "genuine foreign institutional investors" (long term pools of capital) painstakingly fill in the foreign institutional investors application forms and sit on the plane as the Indian authorities thoroughly check them out, to ensure they are sound people.

    On the other hand, the P-Note pool of money - hot, short-term money - that gets India exposure via Participatory Notes does not even have to fill in that health examination form. Their broker fills it out and confirms they are good people!

    Imagine an airline crew in Shanghai airport vouching that the passengers are not affected by swine flu - and signing the form on their behalf. The Chinese would take the crew out of the plane and shoot them or send them off to the hinterland.

    In India, we worship these unknown pools of capital - and shoot ourselves in the foot.

    Finance Ministers of this country have, time and again, made trips to Tokyo, Hong Kong, Singapore, London, and New York to pay homage to these great hedge fund and P-Note owners.

    Rather than being suspicious of short-term money, India welcomes it. We don't seem to understand that we need pension fund money to build India's economy over the long term.

    Our Indian ministers have probably never visited many of the pension funds. They generally don't sit in exciting cities. And the brokers don't really want those pension fund folks investing in India. Because they buy shares and hold them for 5 years or more, the brokerage commissions will collapse and the brokers will be out of jobs.

    Unlike China, India is not willing to learn from its mistakes.

    When questions are asked about P-Notes, the treatment is similar to that of the ambulance incident with the SARS affected patients.

    We will ooh, and aah, and steer the discussion towards thoughts on building a world-class and open capital market.

    Our intellectuals mislead us and get caught in their own web.

    After the election of the Congress-led coalition, many commentators and representatives of the intellectual community came on TV and said, "We hope this new government will allow higher foreign equity ownership in insurance companies".

    Why? Pray tell, why?

    Because, they said solemnly, India needs long-term capital to sustain its development.
    "But, in India, we will continue debating and discussing and throwing intellectually stimulating arguments to explain why what we did in the years 2006 and 2007 was not wrong - and therefore there is no need to learn from the past."

    I was laughing - and crying.

    It is true that India needs long-term capital.

    But then - this same set of people - go about saying that banning P- Notes is a bad idea.

    On the one hand, they say India must have long-term capital and yet - with a very straight face - they want the Indian stock markets to be reliant on short-term capital via unknown pools of P-Notes.

    Having seen the Indian election results, the P-Note owners are now ready to head back to India to ride the gravy train - and add their own flavor to it by sloshing around playfully with their gambling money.

    "P-Notes need to be banned." The Reserve Bank of India wrote in December, 2003.

    And, they were finally, thankfully, in a limited ban and phase out by October 2007.

    But by October 2008, P-Notes were back in action.

    We are back to the future, and looking at an ugly past

    India should only accept long-term foreign capital via "genuine" foreign institutional investors. This is not about making the markets a more "perfect" place and advocating "price discovery".

    Speculation and price discovery is not an end in itself. Markets are not gods to be worshipped. They are created to help an economy reach its goal.

    But, in India, we will continue debating and discussing and throwing intellectually stimulating arguments to explain why what we did in the years 2006 and 2007 was not wrong - and therefore there is no need to learn from the past.

    Because the past mistake was not a "mistake", it was just an event in time that occurred and had to do what it had to do.

    I stand by what I said in October 2008 - and reiterated again after May 15th - one can make a case for the Bombay Stock Exchange's BSE-30 Index to head back to a new peak of 21,000 by June 2010.

    A better economy, better company results - and higher foreign institutional investors flows are all positives for the market. It could happen.

    But if P-Notes are a part of that rise - god help us. Because some event in the United States will frighten the owners of short-term capital and then we will see how pigs can flap their wings.

    Swine flu or swine flew - I don't know which one is more frightening. But India is vulnerable - and could be attacked on two fronts.

    Regards,

    Ajit Dayal
    for The Daily Reckoning

    P.S. You can catch Mr. Dayal at this year's Agora Financial Investment Symposium in Vancouver, British Columbia. This year's event promises to be the best on record, and it is already 70% sold out...so secure your ticket now. Get all the information you need here:

    Agora Financial Investment Symposium, July 21-24

    Editor's Note: Mr. Dayal founded Quantum Advisors, India's first equity research house, in 1990. Quantum Advisors manages India-dedicated portfolios across equity, private equity, fixed income, real estate, and alternative asset classes. He was previously Deputy Chief Investment Officer for Hansberger Global Investors, where assets under management grew from $2 billion to $5 billion during his tenure. Mr. Dayal also served as lead manager for the $2 billion Vanguard International Value Fund from 2000 to 2004. He earned his Bachelors in Economics from Bombay University and his MBA from the University of North Carolina at Chapel Hill.

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