Introduction

I have long argued that Greece is a hopeless case as long as it has to use the Euro as its currency. It cannot now and will not ever be able to compete with the more efficient Eurozone members (Germany, Austria, and the Netherlands). It appears the IMF is starting to understand this. There is also evidence of disagreements between the IMF and the strong Euro countries about next steps. In what follows, I briefly review the Greek case and what it means for the other “Weak Sisters” (Portugal, Spain, Italy) and world markets in the weeks ahead.

Greece – How Grim Can It Get?

So far, Greece has received €20 billion from the IMF and €60 billion from Euro countries. The money is doled out in tranches, the idea being that Greece has to meet certain performance targets before getting each tranche. It recently failed to achieve its targets but still got the latest tranche (€2.2 billion from the IMF and €5.8 billion from Euro countries because of just how desperate the situation is.

In the meantime, lenders are being asked to take a 50% “haircut” (for more on when a default is not a default, see my earlier article). The talks are not going well. There is a lot of money betting on a complete default. What will happen? How many have to sign up for the 50% haircut? I quote from the latest IMF Greek Standby Review:

“Should the debt exchange only reach 50 percent participation, instead of the near universal participation assumed so far, debt would peak at 179 percent of GDP, and begin to stall at around 145 percent of GDP post-2020. Even if the EFSF [Euro countries] covered the financing gap created by lower PSI [Greek creditors] participation, the debt would end at around 130 percent of GDP by end-2030….this level is already above what might be considered sustainable and moreover showing an only limited downward trend.”

The “haircut” talks have broken off. And on “haircuts”, there is one other point worth noting: the Greek banks. They hold a lot of Greek sovereign debt. Again, from the IMF Review:

“Current bank portfolios of Greek government bonds (GGBs) have a nominal value of about €45 billion (€39 billion book value after June 2011 impairments), compared to an aggregated core capital of €22 billion.”

Most of the domestic GGB holdings are with the six largest Greek banks (97 percent). In short, a write down/haircut on Greek sovereign debt of 50% would effectively bankrupt the six largest Greek banks.

The IMF–Mandated Reforms for Greece

When the IMF operates on its own, it goes into a country and figures out has to be done to turn things around. This will normally involve reducing the government deficit, reducing the rate of increase in the money supply, and various other policy changes). It then fashions a “standby agreement” with the country whereby it can get money from the Fund in tranches for the achievement of stated progress targets. In the case of Greece, the IMF focused on what Greece would have to do to become competitive using the Euro as its currency.

In all the years I have been covering the IMF, I have never seen such a long list of policy changes being demanded of any country. The general categories include: fiscal reforms, pension reforms, health sector reforms, Social Security reforms, government performance reforms, and economic system reforms. In order to achieve these objectives, the Greek government has agreed to foreign technical assistance in more than 20 different fields. Ok. So maybe if Greece did everything on the IMF list, they could stay in the Eurozone and compete with the Germans. But don’t hold your breath. This will not work.

The IMF Got It Badly Wrong

The IMF is aware that austerity policies cause unemployment to grow. Its own research concluded that a fiscal consolidation of 1% of GDP results in an increase of .3 percentage points in the unemployment rate. But take a look at what has happened in Greece. Things have gone terribly wrong. As Table 1 indicates, things are bad and getting worse. Just look at the revised projections for unemployment and growth.

Table 1. – IMF Projections and Reality

Source: IMF

I can imagine discussions going on among professional staff within the IMF. Some realize this effort is not going to work and are extremely angry that they got roped into this effort with the Euro countries. Others, the statesmen/diplomats of the Fund, are trying to hold things together. But the anger and frustration are growing.

Evidence of Friction

Last weekend, Andy Dabilis wrote a story documenting growing friction between the IMF and Euro countries over the Greek program. The Fund is apparently upset that Germany and other strong Euro countries has focused almost completely on getting Greece to reduce its government deficit. The IMF is now saying this one dimensional approach has failed. The IMF is upset that Greece is not being pressured by its Euro partners to go after tax evaders and implement the myriad of policy reforms discussed above. Dabilis reports that the IMF was “attempting to distance itself from a ‘counterproductive set of austerity measures’ imposed on the country under the insistence of the EU.”

Meanwhile, Christine Lagarde, the managing director of the IMF, is telling the Euro countries that the size of the second bailout for Greece needs to be increased by “tens of billions of Euros”.   

In short, everyone is pissed, recriminations are rampant, and the Greek program has failed.

Implications for Other Weak Sisters’ Stabilization Programs

Not clear. Germany will probably continue to insist on reducing government deficits, but the IMF will be looking far more closely at the impact of such austerity measures on unemployment and GDP growth. Recognize that Spain’s unemployment rate is already 23% and much higher for younger workers.

Global Impact

What will be the ripple effect of Eurozone problems be globally? Hard to tell. There is much more bad news to come. But some indication of the effect already comes from the downward revisions of GDP growth. In Table 2, I compare IMF growth estimates made in September 2011 with ones made in April 2010.

 Table 2. – IMF: Revised Growth Estimates

Source: IMF

Sadly for the global economy, things will get worse in Europe before they get better.

Introduction

Over the last 30 years, dramatic changes in the wine industry have occured. From being almost completely domiciled in four European countries (France, Italy, Spain, and Germany), it has spread worldwide to include the US, Australia, Argentina, New Zealand, South Africa, Chile and yes, China (7^th largest producer in 2011).

What changes can we expect in the next decade? The globalization of information is leading to changes affecting all industries. These changes include consolidation, specialization, and new production methods. These changes are affecting the wine industry as described below.

Consolidation

In wine, as with other alcoholic beverages, there are large economies of scale to be realized in marketing and distribution. As a consequence, there has been tremendous consolidation.

Table 1 provides just a hint on the enormity of the consolidations underway. Constellation is the largest wine company in the world, with Wine Business Monthly estimating that it sold 102 million cases globally (E&J Gallo global sales are estimated at 80 million). Note the number of brands each company has. In addition to brands, Bronco claims to have 585 wine partners. Fred Franzia of Bronco says they have more than 50 square miles (32,000 acres) of vineyards planted. Much of its business involves selling grapes to others. 

Table 1. – Leading Wine Companies and Their Brands

Source: Wine Business Monthly

But the consolidation goes beyond what is indicated above. Ste. Michelle is owned by Altria, the second largest tobacco company in the world (behind China National). And the 8^th largest wine company is owned by Diageo, the largest alcoholic beverage company in the world.

Specialization: Grape Farmer – Wine Maker – Wine Seller

Merriam Webster defines a vintner as a wine maker/merchant. That is how it used to be: wine makers usually sold the wines they made. In fact, it used to be that the grape farmer made the wine and sold it. No more. The consolidation described above has taken place largely because of the tremendous economies of scale in marketing and distribution. But specialization is also taking place in growing grapes and making wine.

So today wine entrepreneurs are thinking – why is grape farming any different than any other form of farming? Traditionally, grape farmers have been the vintners: they have grown grapes, made their wines and sold them. But why does this have to be? Why should a grape farmer know how to make good wine better than anyone else? So wine entrepreneurs are developing their own cadre of wine makers to scour the globe looking for grapes to make good wine. And to sell the wines they make? They buy up well-known wine brands and develop new ones.

This can perhaps best be seen in looking at what Fred Franzia of Bronco and John Casella of Yellowtail have done. Much of what follows comes from a great book by George Taber. Both are true revolutionaries, but their approaches are very different. Franzia gained notoriety via his Two-Buck Chuck (Charles Shaw) wines sold through Trader Joe’s. And Casella’s Yellowtail grew so rapidly that some estimate it now constitutes 50% of US wine imports from Australia. Their differences: Consider first grape growing. As indicated above, Franzia has 32,000 acres in wine growing. How does he use these grapes? Some he sells off as grapes/grape juice, some he makes into bulk wines (and sells off), and some he uses for his own wines. Here is a Franzia quote from Taber’s book:

“People don’t understand that we’re both buyers and sellers…. We buy grapes, and we buy wine. But we also sell grapes, and sell wines. We try to sell for more than we pay. We buy at $4 and sell at $6. And we do the same thing every day.” But with all his grape growing, Franzia says his wines only use 55-60% of his own grapes. He adds that his wines will never be 100% from his own grapes.

While Franzia is a grape farmer, Casella does very little grape growing. According to Taber, Casella grows only 5% of the grapes that go into his wines. The rest come from 650 different sources. He has 4 staffers that do nothing but buy grapes for him.

When it comes to making wine, Franzia and Casella are similar. Franzia has a team led by Ed Moody while Casella has a team of 11 wine makers headed by Randy Herron. And they make wines people like. A famous example is a Charles Shaw Chardonnay selling for $1.99 winning the 2007 California State Fair blind tasting wine contest against 350 other contestants where the average price was $28.50.

Casella, realizing that US consumers were used to relatively sweet wines, had his winemakers develop sweeter wines for the US market. Critics say the Yellowtail wines are getting better. And Casella has developed a new “Reserve” line of wines that are aged in oak with suppliers from France and the US.

Neither of them has any problem selling their wines through supermarkets, drug stores, whatever. Charles Shaw is sold exclusively at Trader Joe’s but his other 110+ brands can be found in any retail outlet with a wine license. And Yellowtail can also be found just about anywhere, including Costco.

What do these two revolutionaries tell us? No need to be a grape farmer – Casella is not. If you have good wine makers, they will find grapes to make good wines. Even though Franzia is a grape farmer, he (or more specifically his wine makers) buys grapes from others for his wines. And rest assured, these revolutionaries are not alone. According to Wine Business Monthly, Castle Rock ranked as the 25^th largest wine seller in the US, “owns no vineyard and no winery. And then we have 90+ Cellars. It buys excess wines with a 90+ ratings from wineries that produce them.

So what does all say about the future of the wine industry? Further specialization. The French regions with families that grow their own grapes to make their own wines will continue as long as people want to buy prestigious, expensive brands. But the future is not with them. The future? Wine makers scour the globe for grapes to make wines that appeal to different palates. “Terroir” will take on an entirely new meaning. Huge marketing/distribution companies will sell the resulting products wherever they can.

Blending

There is another growing phenomenon worth watching. It is becoming increasingly apparent that few people like wines from a single grape. Blending, or making wines from more than one grape, has been around for a long time. Even Champagne, unless it is a Blanc de Blanc, contains at least one additional grape for coloring or flavoring. And the Côtes du Rhône region of France has been making very good and reasonably priced blends (usually including Grenache, Syrah, and Mourvèdre) for time immemorial.

So what can we expect? Well, wine makers will no longer tied to particular wine growing plots. Instead, wine makers will be instructed to find grapes anywhere they can to make wines that taste good. We can expect more blending.

Conclusions

Assuming I am right about the future, what do we think? I am excited. I see more wine flavors and lower prices. And while I am quite content with the excellent Yellowtail Reserves (Pinot Grigio, Chardonnay, Cabernet Sauvignon, Merlot, and Shiraz) at $9, I am always interested in trying something new – grapes I don’t know and blends still to be discovered.

It will be very easy to become overwhelmed by the number of brands being marketed – from Table 1, I count 340+ from just the top six wine companies. So what is one to do when visiting the drug store, supermarket, and/or liquor store to buy wine? Drug stores and supermarkets sell wines at low prices, so if you know what you want – fine! But in liquor stores or wine shops, try to find someone who is really knowledgeable and hard working (they have to be hardworking to stay ahead of the curve), and see what they come up with for you. And as I have suggested, have your own wine tastings at home.

Wine “futures” should be exciting!

]]> http://www.morssglobalfinance.com/the-future-of-the-global-wine-industry/feed/ 4 http://www.morssglobalfinance.com/global-banking-what-should-be-done/ http://www.morssglobalfinance.com/global-banking-what-should-be-done/#comments Mon, 09 Jan 2012 16:59:21 +0000 Elliott Morss http://www.morssglobalfinance.com/?p=1154 by Elliott R. Morss

Introduction

US bank purchases, packaging and trading of mortgages and their derivatives in late-2008 resulted in the US banking collapse and the global recession. European bank purchases and packaging of Greek and other sovereign debt is close to causing another global meltdown. That leads to the question posed by the title: what should we do about it. In the following article, I consider several viewpoints on what should be done.

The Bhidé and Lounsbury Suggestions

 In a NYT op-ed piece, Prof. Amar Bhidé recommends:

•  governments should fully guarantee all bank deposits;
• governments should impose much tighter restrictions on risk-taking by banks, and finally,
• banks should be forced to shed activities like derivatives trading that regulators cannot easily examine.

John Lounsbury, Managing Editor and Co-founder of Global Economic Intersection has suggested:

“…the depository function of banks should be regulated as are public utilities.  That public utility function is in fact institutionalized by the FDIC within the depository limits of that program.  The investments associated with such deposits should be regulated to a much higher security/risk standard than many other forms of banking traditionally known as investment banking.  It is only logical that the public utility should be segregated from the investment banking activities.” 

Guaranteeing Bank Deposits

Felix Salmon has argued that bank deposits need not be guaranteed. He sees little change of a run on banks, either in the US or Europe. I think he is crazy, particularly as it applies to Europe. I quote from one of my recent pieces:

“A bank run occurs when depositors, worried about the safety of their deposits, pull them out. This causes real problems inasmuch most banks keep less than 10% of their deposits in cash. So what would I do if I had Euros deposited in any Eurozone bank? That is easy. I would pull them out immediately and stuff them under a mattress.

Why? What if Greece decides it has to get out of the Eurozone and go back to its own currency? Yes, there is a way that I described in a recent article whereby you could keep your Euros and they would become interchangeable with the new currency at market rates. But do I trust the Greek or any other European government to implement such a program? No.”

In my view, the danger of bank runs in several of the EUR countries is quite high. And the very last thing any country needs is a bank run: deposits cannot be covered and citizens panic. The best way to at least mitigate the chances for bank runs is to guarantee deposits.

Tighter Restrictions on Risk-Taking

Both Bidé and Lounsbury believe risks should be lowered and more tightly regulated in depository banks.   

Ashwin Parameswaran and I question whether this can be done. I quote from Parameswaran:

“There are a couple of problems [here]…for one it may not be possible to effectively regulate bank risk-taking. On many previous occasions, I have asserted that regulations cannot restrain banks from extracting moral hazard rents from the guarantee provided by the state/central bank to bank creditors and depositors. The primary reason for this is the spread of financial innovation during the last fifty years that has given banks an almost infinite variety of ways in which it can construct an opaque and precisely tailored payoff that provides a steady stream of profits in good times in exchange for a catastrophic loss in bad times. As I have shown, the moral hazard trade is not a “riskier” trade but a combination of high leverage and a severely negatively skewed payoff with a catastrophic tail risk.”

 I would add another reason: regulations won’t work because bank regulators cannot anticipate what is needed. For how long have bankers been working on regulations? We have had three sets of Basel Accords – I, II, and III. Each of these accords was an attempt to score the more and less risky assets held by banks. So after all this work, how was sovereign debt scored? Just as good as cash! Forget regulations: they won’t work. Instead, depository institutions should be limited to making and managing their own loans with no trading allowed.

How Do We Get There?

Two steps need to be taken:

 1.                  Split Off Bank Trading Operations;

2.                  Require Banks to Make, Hold, and Manage Their Own Loans.

1.      Split Off Bank Trading Operations

Parameswaran is horrified by this notion and does not think it can be done:

“Amar Bhide’s idea essentially seeks to turn back the clock and forbid much of the innovation that has taken place in the last few decades.”

As an aside, this comment reminds me of what Larry Summers said when Glass-Steagall was overturned. He welcomed the overturning of Glass-Steagall as “a system for the 21^st Century”.

 “the innovation that has taken place in the last few decades”?? Hmm. What have we gotten from these innovations? So far, two major banking collapses and a global recession that ranks 2^nd only to the ’29 collapse.

 Back to Parameswaran. He claims:

“There is simply no way that large banks, especially those with a large OTC derivatives franchise, can shed their derivatives business and still remain solvent.”

Parameswaran is missing the point. There is no need for them to liquidate their holdings. What would happen, as it did in the ‘thirties, is that the depository institutions’ investment banking arms would be sold off and the depository banks would get cash payments for what they were worth. The high-paid executives would leave with their products inasmuch as there would be no justification for their high compensation if they stayed behind. Let them play their “combination high leverage and a severely negatively skewed payoff with a catastrophic tail risk” games somewhere else.

2.      Require Banks to Make, Hold, and Manage Their Own Loans

This is what banks did (before the “innovations”), and it required them to focus on the spread – the difference between what they paid to attract deposits and what they made on their loans. This was their life blood – their loans could not fail or they would collapse. Think how different the incentives are today – buy, package and sell loans – make money on the commissions – don’t worry about the quality of loans, you will be selling them off – the more you sell off, the more commissions you make.

Why did the market for mortgage-backed securities hold up so well when everyone knew there was a real estate cycle? Why was anyone buying Greek sovereign debt in 2007 when it was clear Greece was on a non-sustainable path? Because the banks did not care about risk: they planned to sell everything off and make money on the commissions.

Will this change really make a difference? I think so: the incentive change is so profound that banks will again be forced to think seriously about the quality of the loans they are making.

Parameswaran disagrees:

“Although this would seem to be a sufficiently narrow mandate to prevent rent extraction, it is not. Banks can simply lend to other firms that take on negatively skewed bets. You may counter that banks should only be allowed to lend to real economy firms. But do we expect regulators to audit not only the banks under their watch but also the firms to whom they lend money?… I outlined how the synthetic super-senior CDO tranche was the quintessential rent-extraction product of the derivatives revolution. But at its core, the super-senior tranche is simply a severely negatively skewed bond – a product that pays a small positive spread in good times and loses you all your money in bad times. There is no shortage of ways in which such a negatively skewed payoff can be constructed by simple structured bank loans.

I do not believe Parameswaran is right because of the fundamental change in incentives that holding their own loans would force on banks. But who knows? My suggestion? Try it my way. Watch it carefully. If it appears Parameswaran is right, adopt a severe public utility model and require that depository institutions limit their investments to US Treasuries or in the case of the Euro banks, ECB paper.

Conclusions

Some form of what has been discussed above should be adopted. Why? Because none of the steps taken to date have significantly reduced the chances of another bank meltdown. What are the chances for meaningful reforms? Not good. The US and European banks’ lobbies are too strong.

Introduction

After all the hype Margin Call received, I expected more. In my view, the movie was a real disappointment: it said virtually nothing about the banking crisis: just a bunch of people I can’t feel sorry for losing their jobs. And on that theme, how about the millions of people who lost their jobs because of the foolish and destructive things the bankers were doing?

After seeing the flick, I read some of the reviews. They were positive, with the emphasis on how entertaining the movie was.  OK: the primary aim of movies is to entertain. But I think a movie providing a more complete picture of what happened could be even more entertaining than Margin Call. I offer an outline of such a movie below.

Scene One: 1933 – Glass-Steagall Act Enacted

The movie would start with an actor playing Senator Carter Glass arguing for passage of the Glass-Steagall Act. Glass, a former Treasury secretary and the founder of the U.S. Federal Reserve System, was the primary force behind the Act. Glass would explain why trading activities were too risky for banks and why the “investment banking” activities of banks had to be split off.

Scene Two: 1998 – Glass-Steagall Overturned

In the next scene, we would again be in Congress – this time for the repeal of the key provision of the Glass-Steagall Act. An actor playing Sandy Weill would lead off. Sandy owned Travelers, which owned Salomon Smith Barney, and he was arranging a merger with Citicorp. But Citicorp was a bank and Salomon was an investment bank – not a legal merger under Glass-Steagall. So the lobbyists go to work for Weill. In the following year, Congress passed the Financial Services Modernization Act of 1999, known as the Gramm-Leach-Bliley Act. This law effectively deleted the prohibition on commercial banks owning investment banks and vice versa.

An actor playing Treasury Secretary Larry Summers should then say what Summers was quoted as saying: ”Today Congress voted to update the rules that have governed financial services since the Great Depression and replace them with a system for the 21st century. ‘This historic legislation will better enable American companies to compete in the new economy.”

Scene Three – Efforts to Regulate Derivatives

Shortly later, Summers teams up with U.S. Securities and Exchange Commission Chairman Arthur Levitt, Fed Chairman Greenspan, and Secretary Rubin to torpedo an effort to regulate the derivatives market. Actors playing Greenspan and Leavitt should concede, as they have publicly, that this was a big mistake. Summers should be quoted as well on his back peddling in saying that not regulating AIG’s financial insurance activities was outrageous.

Scene Four – Changing Bank Objectives

The scene should switch to a single bank. But instead of focusing on the market collapse and lost jobs (Margin Call), the first scene should be the bank president telling the troops that the time for holding onto (and worrying) about their own loans was over: the future was in writing up and selling off as many loans as possible for commissions. Traders would then buy them back, package them, and sell them off again.

Next the new bank hires: instead of green eye shade people worrying about loan quality, aggressive salesmen to sell bank mortgages and other loans would be brought in. And young MBA types to develop derivative packages would also be recruited.

Portraying this change in bank objectives and incentives is fundamental to understanding the reasons for the Western banking collapse.

Scene Five – Bank Insurance

It was not just AIG that sold insurance on mortgage-backed securities. Banks did as well. This could be captured in a short scene where a bank “seller” tells his boss that one of their major clients is showing some reluctance in buying a mortgage-backed security package. His boss responds: “tell the client the bank will insure the package”.

Scenes Six & Seven – Loss of Mortgage Documentation

The loss of mortgage documentation is critical, both for understanding why the mortgage-backed securities market collapsed as well as why finding ways to help mortgage recipients failed. On the former, more than 90% of mortgages are performing well. Why, then, would the whole market collapse. Lack of documentation – nobody knew where the bad mortgages were. These points can be captured in two related scenes.

First, a scene focuses on the packaging process where two bank staffers talk about keeping or not keeping accurate documentation trails on mortgages being packaged. The scene should end with them agreeing on taking shortcuts. A good final line might be “I am sure if we asked Joe in the buying department, he would have no documentation on the mortgage derivative packages he is buying.”

Second, a scene where the bank president calls in his mortgage packagers/buyers/sellers and said I want to sell off all our non-performing loans.  The buyers and packagers would then say “we have no idea which mortgages in our derivative packages are performing and which are not”.

Scene Eight – The Market Collapse

We are now at the point where Margin Call started. The real estate market starts down, banks want to sell of the mortgage-backed security packages, but nobody knows where the 90% good mortgages are, so the whole market tanks. And because nobody knows where the bad mortgages are, all MB holders become suspect. So banks won’t lend to one another…. A real quote from a Senator following a briefing with Treasury Secretary Paulson could set the stage. This could be followed by a series of panic calls among bank salesmen.

The AIG Bailout

The AIG bailout warrants a movie of its own. However, as an end to the moving I am proposing, I offer the following.

Scene Nine – Early September Phone Call

Lloyd Blankfein, the man who replaced Paulson as the head of Goldman, calls the now Treasury Secretary Paulson. Blankfein: “We need the insurance money AIG owes us immediately.” Paulson: “I will see what I can do.” Paulson calls Tim Geithner, the head of the Federal Reserve Bank of New York. Paulson: “I want you to lend AIG $85 billion so it can make insurance payments to banks.” Geithner: “OK. Let’s arrange a meeting with AIG”.    

Scene Ten – The Mid-September Meeting

In mid-September 2008, Secretary Paulson and Geithner met with senior executives of AIG and the Bank’s headquarters in New York. Guess who else shows up at the meeting? Lloyd Blankfein. Geithner asks Paulson why Blankfein is there. Paulson says “because I asked him”. Geithner agrees to lend AIG $85 billion. Ultimately, the government pledged $182 billion to save AIG.

Scene Eleven – November 2008 – Pay Full Value

In the October-November 2008 period, claims against AIG mounted. Inasmuch as AIG was effectively insolvent without massive government backing, senior AIG staff believed it could settle claims at 60 cents on the dollar and were prepared to move ahead on that basis. Paulson said “No. Pay out 100 cents on the dollar”.

Scene Twelve – Attempted Cover-up

Geithner holds a meeting with AIG and says: “in your next report to the SEC, do not name the banks that you paid.” AIG official responds: “I doubt the SEC will accept a statement that does not include the names of recipients getting more than $1 billion from us.” Geithner: “try it.” On December 30, 2008, Jeffrey P. Riedler, Assistant Director of the SEC, send a letter to AIG requesting the details on who got paid. Geithner was able to keep the names from being released until March 15, 2009.

The movie ends with the following Table.

AIG Payments

Source: AIG

Conclusion

In my humble view, this would make a great movie.

But until I get a call from Harvey Weinstein or Oliver Stone, the best movie on the banking collapse is Charles Ferguson’s “Inside Job”.

]]> http://www.morssglobalfinance.com/margin-call-%e2%80%93-a-real-disappointment/feed/ 2 http://www.morssglobalfinance.com/investing-in-2012-%e2%80%93-what-we-have-learned-from-panic-times/ http://www.morssglobalfinance.com/investing-in-2012-%e2%80%93-what-we-have-learned-from-panic-times/#comments Mon, 02 Jan 2012 18:28:25 +0000 Elliott Morss http://www.morssglobalfinance.com/?p=1138 by Elliott R. Morss, Ph.D.

Introduction

Since May 2009, I have recommended investments in emerging market countries. In part, I did this to bet against the dollar. But also, emerging market countries’ growth rates were high – they had middle classes whose growing demands would get them out of the global recession far more rapidly than the “mature” Western countries. In addition, their debt/deficit rates were low relative to the US, Europe, and Japan.

What has happened? My recommendations were hardly impressive. As Table 1 indicates, the S&P 500 did slightly better than the simple average of the emerging market ETFs and mutual funds that I recommended.

Table 1. – Investment Results

Source: Yahoo Finance

 What Went Wrong?

There was nothing wrong with the growth projections: emerging market countries have grown rapidly while Western nations continue to have high unemployment and growing debt. And on top of this, European banks are near collapse and the US government economic policy making has become dysfunctional.

There were three reasons my recommendations were mediocre:

•  Stock market investing is a “random walk”;
• Western traders and “thin” stock markets in emerging nations;
• Panic.

Random Walks

Paul Samuelson is credited with developing the mathematical theorem showing that “properly anticipated futures prices fluctuate randomly”. That means all new information is immediately reflected in stock market prices. How immediately? With the large amount of computer-driven trading that goes on today and professionals following every company day and night, any new information will be reflected in stock prices before I get it. Picking stocks is a losing game for individuals. But many of us continue to look for an “edge”. If the random walk theory is correct, all stocks have an equal probability of going up or down. So it is not too much of a surprise to see emerging market stocks performing about the same as the S&P 500.

Western traders and “Thin” Stock Markets in Emerging Nations

Table 2 provides data on the capitalization of selected stock markets, by country. In every country, the holdings of residents far outweigh the holdings of foreigners. However, the determinants of prices are trades, and investors from the developed world are the dominant equity traders globally. Take a look at the trade ratios in Table 2, the total value of trades divided by the stock market(s)’ capitalization. Note how low they are in many emerging market countries. This means very little trading. But trades are what determine prices. So what happened in emerging markets? The Westerners bought in 2009 and sold more recently. And even relatively small trades by their standards had a tremendous impact on equity prices. Some of this trading was value driven, but as with other commodities, there has also been considerable speculative trading. Speculative trading has occurred in advanced equity markets as well, but the speculators will normally have less of an impact their because of higher capitalizations and higher trade ratios.  

Table 2. – Stock Market Capitalizations, End-2010 (in bil. US$)

Source: World Federation of Exchanges

Panic

Since 2008, there have been numerous instances of global financial panic. What happens in such times? Foreigners liquidate their holdings of overseas assets. If they hold any foreign assets in panic times, they will hold US dollars.

Not Just Correlations – Look at the Betas

A number of pundits have recently remarked that stock markets are increasingly correlated: when the S&P 500 goes up/down, so does the Tokyo market. But there is another factor of equal or greater importance to investors: how much the Tokyo market rises or falls relative to the S&P 500. The Beta coefficient captures this: it gives the average percent increase/decrease other markets for any percent increase/decrease in the S&P 500. These differences are reflected in the Beta coefficients of my recommendations. Table 3 gives the Betas for my investment recommendations for the May 2009 to the end of 2011 period.

 Table 3. – Betas vs. S&P 500

Data Source: Yahoo Finance

 Note the high coefficients for South Africa (EZA), Brazil (EWZ), Emerging markets (EPP), Pacific, excluding Japan (EPP), South Korea (EWY), and Latin America (PRLAX). For a 1% increase/decrease in the S&P 500, they go up/down on average 30% more/less. The coefficients for China (MCHFX) and India (MINDX) are much lower, probably reflecting the high capitalizations of their markets and heavy trading (at least in China).

What Does This Tell US for 2012?

If global fear and panic continues, the market whiplashes will continue. A lot remains worrisome. As I have written, things will get worse in Europe before they get better. The US pull-out of out Iraq has left a completely unstable nation, threatening oil supplies and worse. However, the US is showing some signs of recovery. So let’s at least consider what should be done if panic subsides a bit.  

Weaker Dollar

Panic is propping up the dollar. I believe even more strongly than I did 3 years ago that the dollar will weaken in future years. Despite panic and other problems that tend to strengthen the dollar, it has weakened somewhat against major currencies since May 2009. With the deficits, debt, and dysfunctional government in the US, the dollar should weaken much more. So I continue believe in betting against the dollar, and that means getting your money into other currencies/commodities.

Table 4. – Dollar Losses vs. Major Currencies

Source: Oanda

But how? Jim O’Neill and his partners at Goldman have come up with a new list of countries to consider. But since I only like 2 of his 4 BRIC suggestions, I go back to square one by looking at countries:

•  with 15 million people or more;
• that have sizeable equity markets;
• that are projected to grow by 3% or more in 2011.

Table 5. – Country Growth Projections

Source: IMF: World Economic Outlook

What countries on this list bother me? Right now, the Middle East is too risky for investments. Russia is also problematic: a country that is accustomed to being run by a dictator with no history of allowing markets to work. And while there is corruption in all countries, Transparency International reports there are only 7 countries in the world more corrupt than Russia -  Tajikistan, D.R. Congo, Guinea, Kyrgyzstan, Venezuela, Angola, Equatorial Guinea, and Burundi.

 I have looked at Mexico relative to other Latin American countries, and it has real problems. It is running out of oil, a major export. It depends too much on the US for markets, and it has a real drug trafficking problem.

 So now let’s look in a bit more detail at the remaining countries. Table 6 combines growth prospects of countries with their unemployment and inflationary pressures.

Table 6. – Economic Conditions In Selected Countries

Source: IMF: World Economic Outlook

Argentina’s inflation looks dangerous enough to exclude from further consideration.  

Now let’s look at the debt and deficit problems of these countries. Both India and Sri Lanka are running large government and current account deficits. A couple of years ago, I was positive on India. No longer. Unlike China, it has not invested in needed infrastructure. Perhaps its government is too democratic to rule effectively at this time of rapid growth.

 Table 7. – Debt and Deficit Problems in Selected Countries

Source: IMF: World Economic Outlook

These considerations leave us with the following 13 countries for further consideration: Brazil, Chile, China, Colombia, Indonesia, Korea, Malaysia, Peru, Philippines, South Africa, Taiwan, Thailand and Turkey. But are their markets overpriced? Table 8 provides price earnings ratios for selected country and region ETFs and mutual funds. In light of discrepancies that turned up, I  have given ratios from both Yahoo Finance and CNN Money

 Table 8. – Price Earnings Ratios

Putting It Altogether – What To Do?

Go back to the Betas: they are important. They mean that if financial panic subsides, emerging markets should way outperform the markets of developed nations. This will happen in large part because “big finance” from developed nations will buy them again. One other thing will happen if panic subsides: people will sell dollars. The dollar will weaken. Betting against the dollar will pay off.

When panic subsides, I will start by looking at selections in Table 8 with price-earnings ratios of 11 or less.

My Investment Position

I generally agree with the argument that trying to time investments is futile. But with what has been happening these last two years, I have pulled most of my money out of emerging markets equities, concluding that a return of 4-6% is preferable to the equity roller coaster. I own Vanguard’s Emerging Market Income Fund (TGEIX) yielding more than 6%, the less risky Wisdom Tree Emerging Market Local Debt ETF yielding 5%, and the Fidelity Real Estate Income Fund (FRIFX) yielding 5%+. For reasons discussed in an earlier article, I sometimes prefer mutual funds to ETFs.

So when is time to go back into emerging market equities? We know Washington will remain dysfunctional indefinitely. Let’s wait and see what happens in Europe and the Middle East over the next couple of months.

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