Saturday, September 25, 2010

Final Thoughts on China

All of my life, the U.S. has been the engine of growth for the world. That is no longer the case, as China has clearly taken our place. While that may be sad, I don't think it is anything to be feared.

During my travels over the last two weeks or so, I've focused on China, but it is time to move on. For now, here are some concluding thoughts on "The Chinese Century".

In the near term, China's importance is clearly growing. Investing there is a smart thing for growth investors. However, the Shanghai stock exchange is not transparent and very volatile. If you have a weak stomach, stay out.

In the mid-term (5-8 years), I especially like consumer oriented stocks in China. However, don't do this on your own. Find a good, specialized mutual fund for this targeted exposure.

In the long-term, China faces enormous problems, with the fastest aging population on the planet. Their centralized government has done an excellent job of guiding the economy so far but are only human. No centralized government can consistently allocate resources more efficiently than the market. They will screw this up! "Buy and Hold" is not the right strategy for China.

Now, back to the U.S.-- my beloved America!

Friday, September 24, 2010

Save Your Breath, America!

The Bush Administration started applying pressure on China years ago, to allow their currency to increase in value. This makes their exports more expensive to foreigners who buy them, like the U.S. As a result, foreigners buy less, which means China produces less, and fewer Chinese workers are needed. Layoffs increase and so does social unrest.

The Obama Administration has substantially increased that pressure on the Chinese currency. Yesterday, Chinese Premier Wen said a 20% appreciation of the Yuan would cause widespread bankruptcies in China. As their bankuptcy system is rudimentary, the impact would be far greater than we would expect.

The single more important takeaway from this series on China is how critical it is to understand the driving force behind all their decisions, i.e., stay in power by avoiding social instability. Any discussion of China without that clear understanding is wasteful.

So, Wen has made it clear that a 20% appreciation is not going to happen. Most currency analysts believe it needs to appreciate 20-45%. If Obama pushes for a fairly priced Yuan, he is far more likely to get a trade war, which would be far worse for the U.S. Like a rat, Wen is backed into a corner and likely to bite!

Thursday, September 23, 2010

What Chinese and Americans Have In Common . . . Taxes

The Chinese have a progressive tax on income, which means your tax rate increases as your income increases, similar to ours. However, they have no estate tax, at least not yet.

As income inequality increases, so does social instability, which is the greatest fear of the Chinese government and can hardly be emphasized enough. To take more from the rich, there is now growing pressure to tax the estates of the rich.

What amuses me is the argument by the Chinese Academy of Social Sciences that says "Before imposing inheritance tax on the rich, the government must study international taxation laws and practices thoroughly. What happens if some countries do not impose inheritance tax at all or have much lower rates and China decides to implement it hastily? It could cause many rich Chinese to migrate abroad and lead to unnecessary outflow of domestic capital, harming the national tax revenue and even the national economy."

This is pure classical economics, which says capital flees taxation and goes where it is appreciated. Funny, I haven't noticed too many Americans leaving our great country just to avoid taxes . . . that aren't even paid until after they're already dead anyway. Let me know if you do!

Tuesday, September 21, 2010

Peeling the Onion....

Last week, I marveled that China was making the same mistake as the U.S. by letting its Social Security system get as out of control as ours. Digging into this has not been easy, but I have learned that:

1. It started in 1978, when China was still a "socialist-paradise".

2. By 2030, it is expected to be the oldest, on average, population on the planet.

3. By 2040, over 28% of the population will be 60 years old or older.

4. Today, each recipient is supported by 3.5 workers, which drops to 2.0 workers in 2035.

5. Men working in "arduous conditions" can retire at 55 and women at 45.

6. They do have to pay into the system 15 years, compared to 10 years in the U.S.

7. But, the people don't see the problem coming, i.e., 90% are opposed to raising the eligibility age.

Remembering the single most important objective of the government is to maintain social stability, in order to maintain control, it is unlikely China will make the necessary changes, maybe more unlikely than the U.S. to make those same needed changes. I just wish both our governments would peel back the onion on this problem and actually address it...silly me...

Deja Vu.....Not This Time

Back in 1986, I was a Vice President with Citibank out of New York, and based in Dallas. With no data to go on, except a general sense of unease about the possibility of serious over-building, I rented a large van for a full day and invited all the best bankers I could to spend a day . . . sightseeing in our hometown. Collectively, we came to the judgment that the office building market in the North Dallas market and the condo market in far east Dallas were headed for big trouble. Fortunately, we immediately stopped lending to those markets. Because we knew there had to be “spillover” damage, we reduced overall lending all over north Texas.

For the last few days, I’ve remembered that experience, as I’ve driven around east China with businesspeople from the Chamber of Commerce. We are seeing an awful lot of construction, epic levels of construction in fact. There are countless “see-thru” buildings. I’m told that one of every three construction cranes in the world are working in China and have been for many years. Based on our experiences back home, most Chamber leaders think China is headed for big real estate problems.

I’m not so sure. Remember: The PRIMARY function of the Chinese government is to prevent social instability and thereby to remain in power.

One of the principle complaints of young professionals is the high cost of housing. Finally, after a long climb, residential sale prices in Shanghai have fallen about 2% since last year, to $2,971 per square meter or about $330 per square foot. Not surprisingly, sales are up 9%. Their unstated policy, I suspect, has been to increase the supply of housing enough to stop the inflation in housing prices. Even if they cause some deflation in home prices, it is unlikely to create a credit problem, since most mortgages require a 40% down payment, unlike the U.S.

Driving around north Texas in a van and east China in a bus . . . are very different!

Sunday, September 19, 2010

Strutting With the Best of Them.......

I was born immediately after World War II. It was a time when America became the most powerful nation on the planet. We had triumphed over evil during the War and “deserved” to be #1 among nations. We were truly “exceptional”. As a young man (and especially when I wore my Army uniform), I walked with a swagger . . . because I was an American and damn proud of it!

As I travel through the provinces around Shanghai, I am again seeing that swagger but from the Chinese, of course. I recall that airy confidence of young men who believe they are exceptional but don’t think I recall seeing that back in the U.S. in a long time. Strutting with an attitude is not the same thing as walking with a swagger.

After being occupied by the Japanese from 1933 to 1944 and suffering thru a four year revolution between the Communists from 1945 to 1949, before the Cultural Revolution when 30-40 million of their countrymen starved to death, and then created the greatest economic leap in history, the Chinese feel they have the right to walk with a swagger. I agree!

Friday, September 17, 2010

The Triumph of Madison Avenue

Certainly, one of the most apparent changes in China from my last visit in 1987 is the western style of clothing, which has been completely adopted by the Chinese. It is not unlike a typical walk thru Chinatown in San Francisco. Who said advertising doesn’t work?

Yet, this is one of those discussions where business bleeds into ethics quickly. If advertising works for clothing, why should we assume it does not work for credit card companies? Anybody is savvy enough to buy clothes, but is everybody savvy enough to manage credit, when advertisers constantly encourage us to use it?

Oh, yeah . . . it is the consumer’s choice, I forgot. But, it’s odd that I haven’t seen a single advertisement for Master Card or Visa since I got here . . .

A Day in the Life of ....China

This nation boasts the greatest number of newspapers, with over 400. It is also accused of having jailed the most jounalists, number unknown. Still, a good read of one day's edition offer insights into Chinese thinking see

1. Pressure from the U.S. to allow the Chinese currency (Yuan) to appreciate is not motivated by any trade protection of Chinese exporters but entirely by the mid-term elections in the U.S.

2. With Beijing selling 1,500 cars every day, it is getting more dangerous to ride bicycles (duh).

3. A widely used form of contraception for young Chinese women is the "morning-after" pill, where it is available at roadside pharmacies without a prescription.

4. If you kill a person with an auto, the driver pays a one-time penalty. If you cripple that person, you may have to pay the person for the remainder of their life. In the city of Xinyi, a man driving a BMW was videotaped running over a 3 year old boy before doing it several more times, to make sure the boy was dead.

5. There is a summit underway in Brussels on how the 500 million strong European Union can cooperate more closely with the stronger 1.3 billion Chinese.

6. Eight tourists from Hong Kong were killed in the Philipines.

7. One of the fastest growing businesses in the urban areas is "online snacks", where office workers call for delivery of snacks, not just food but snacks.

8. The Shanghai Composite Index or CSI was down 1.9%.

9. Life goes on......

What Mao Meant.....?

Mao said that all great men have climbed The Great Wall. What he meant to say was “All great financial advisors have . . . “

Thursday, September 16, 2010

A Rocker Got it Right

As a child of the Cold War, I just assumed I would die in a nuclear war. When I first heard the song by rocker Sting, called “Do the Russians Love Their Children Too?”, I was caught a little off-balance by the question.

Yesterday, I watched an older lady stop a young mother to admire her baby. I saw a man photographing his wife and then she photographing him before a stranger asked if he could use their camera to take a photo of them together. I missed my wife as I watched couples walk down the street holding hands.

Yes, Sting’s rhetorical question is important. The Russians do love their children, just as much as Americans or Chinese or everybody else. It is easy to forget that people are more alike than different . . . Thank God!

We’re #1, We’re #1 . . . Today!

Last month, China passed Japan to become the world’s second largest economy. At current rates, it should bypass the U.S. in 2020, which is a mere ten years away. It may do so, but it is interesting that they are not learning from our mistakes. Already, they are allowing retirement for women at age 50 and men at age 55, along with a comparable Medicare plan. Just ask Greece how that worked out for them!

There is a difference between a budget deficit and a structural deficit. A budget deficit looks at one year. A structural deficit looks at much longer time periods. For example, we all know that Medicare, Medicaid, and other health care costs are ballooning out of control, with or without Obamacare. Politicians talk about the budget deficit but simply resort to partisan name-calling on the structural deficit.

As we all know, China is running enormous annual surpluses, but I would love to see some numbers on their swelling structural deficit. To make their problem even worse, the U.S. permitted a huge social safety-net partly out of mere humanitarian interests, and because we could afford it at that. China has a far different problem. They face a much greater risk of social instability than the U.S. and politicians may be forced to pander even more to the disaffected.

At this point, I don’t see any scenario that will prevent China from over-taking us, but I am confident they won’t be #1 forever.

Wednesday, September 15, 2010

Paging Gloria Steinam

The flight attendants for Air China are young and pretty, obviously a proven branding campaign for generations. However, just like all flight attendants everywhere, they were over-worked, harassed, and annoyed. Rolling their eyes seemed to be a primary job requirement. Yet, they seem to have more authority than U.S. travelers normally see. When they tell you to close the window, it is not a request. When they tell you to clear the aisles, they mean NOW!

We were served two meals during the 14-hour flight, and I ate the steamed carrots in each . . . nuff said!

Of course, the highlight of the flight was watching the movie of “Alvin and the Chipmunks” in Chinese . . .

A Troubled Economic Paradise

In 1987, I made my last trip to China. Mao had only been dead 11 years, and Deng was still trying to figure out how to use Soviet-style Five Year Plans to unleash the Chinese economy. To me at that time, it was a large, Second-World nation with an agrarian economy. My principle take-away was military, i.e., that China really could field a ten-million man Army, which is still amazing.

Yesterday, as the Air China 747 left JFK over the Atlantic before making a U-turn for the 14 hour flight across North America and the Pacific Ocean, I was expecting the take-away on this trip would be economic, not military. After all, I routinely study most every economic report China issues. One of my concerns has been that China’s economic statistics are less than unbiased and I hoped to get a better feel for it on this trip.

I was thinking how their economy has been growing 3-4 times faster than ours . . . every year for twenty years. It is no wonder they are now the world’s second largest economy. But, how have they done it? The conventional wisdom is that their government has an industrial policy and can actually govern. Furthermore, Deng visited Singapore frequently to see their combination of capitalism as an economic system with dictatorship as a political system and adopted it for his country.

The Free Enterprise system has capitalism as an economic system and democracy as a political system. That didn’t make sense to Deng, who was justifiably fearful of social unrest. The GINI index measures the gap between upper income Chinese and lower income Chinese. It is bad and getting worse, more like a Latin American Banana Republic. Social unrest is an inevitable result of increasing income inequality.

But, is dictatorship the answer to effective governing? Take a look at India, whose economy is growing almost as rapidly as China’s. Yet, they have a firmly established democracy. They are almost as Free Enterprise as we are. Democracy does not preclude a good industrial policy. However, maybe there are democracies, and there are democracies. While they have many political parties, they “ebb & flow” together to make things happen. Maybe, there is a lesson there for us.

I came to China to think about their economic reports. Maybe, I should be comparing political reports between the U.S. and India, not China.

Monday, September 13, 2010

Chinese Water Torture or Capital Torture

Regulators for the world's central banks meet in Basel, Switzerland. On two previous occasions, they have re-written the rules for banks worldwide. Now, we have the third revision, called Basel III.

The more capital a bank has, the less likely it is to fail and need taxpayer dollars. So, why not require banks to have lots of equity? Because it is an expensive source of funds! Banks make their profit on the difference between what they charge borrowers to borrow and what they pay for the funds they lend to borrowers. Checking accounts, for example, are a very cheap source of funds for banks to lend out. Investors who put capital into a bank demand much higher rates of return than checking account holders, reducing bank profits. Not surprisingly, regulators want a lot of capital and banks want very little.

Basel III does require more capital, but not as much as the banks and Wall Street feared. In addition, the new banking requirements are scheduled to phase in over the next seven years. Banks and Wall Street feared something much sooner. So, Basel III is not as tough as Wall Street feared, and bank stocks will likely rise nicely.

Basel III is another step in the right direction, just too slow. Like all generals who keep fighting the last war, regulators are still too focused on having capital to absorb inevitable loan losses, and not focused enough on non-banking activities done by banks using FDIC-guaranteed dollars, like proprietary trading in derivatives.

Saturday, September 11, 2010

More breadcrumbs leading to . . .

Yesterday, it was announced that wholesale inventory levels rose 1.3%, which is the best performance in two years. Sometimes, a rise in inventory means sales have decreased, causing inventories to backing up. However, it was also announced that sales at the wholesale level increased twice as much as expected.

This means wholesalers are re-stocking their inventories . . . because they have reason to believe that they will be selling more out of their inventories. And, I hope they are right!

The trail of economic data seems to be improving again, and I hope it is right, leading to a real, sustainable recovery! This is consistent with my expectation that the market will improve by year-end.

Friday, September 10, 2010

Stealth Globalization

There is no good measure of globalization, a fact that drives economists crazy. Traditionally, we have used the Baltic Dry Index, which measures the cost of shipping dry goods around the world. It's a good start, but here is another.

Every three years, the Bank for International Settlements in Switzerland measures the volume of trading, not in stocks or bonds or commodities, but in currencies. Their latest study found that $4 TRILLION of currencies trade every day. This is more than twice as much as it was five years ago.

Obviously, the more international trade there is, the more international currencies that need to change hands. Does that mean international trade has doubled in the last five years? Only partially!

It also does mean currencies have become another asset class, where investors can make or lose fortunes by simply investing in currencies, like investing in stocks or bonds. Of course, smart investors usually lead the way. They are betting that increased globalization will increase demand for foreign currencies, and they are investing in those currencies.

Lastly, if the dollar resumes its long decline, as I expect, that will also make foreign currencies more valuable. It's just not prudent to be dollar-centric in a globalized world!

Thursday, September 9, 2010

A Good Morning, Indeed!

It's nice to start the day with two pieces of good economic data. First, initial jobless claims dropped more than expected, down 27,000 to 451,000. That makes three jobless reports in a row that have been better than expected. It certainly smells like a bottom in an awful jobs market.

Second, the trade deficit shrank more than expected, from $49.8 billion last month to $42.8 billion this month. Exports were up significantly, and imports were down. This could reflect the improving dollar, but it is premature to make that judgement. If our imports are down because our consumers cannot afford to buy foreign goods, that would be a bad thing. Or, it could reflect improving quality in U.S. made goods. But, exports are clearly up, because the rest of the world is recovering faster than we are.

Futures immediately jumped about 50 points on the news. This looks like the sixth up day out of the past seven. I've been expecting the market to rally, once the election reduces uncertainty, but this seems a bit too soon for that. Interestingly, famed investor Mario Gabelli said this morning that he thinks the market will be up 5% by year-end. I hope he's right!

Friday, September 3, 2010

Economic Rolaids

The Market has been holding its breath, fearful of today's Jobs Report. Coming just before Labor Day, it seemed to be even more important than usual. Hopes started to rise Wednesday when the ISM (Institute of Supply Managment) manufacturing index actually rose more than expected.

Still, most economists were expecting that the U.S. economy had lost about 110 thousand non-farm jobs last month, for the third straight month of losses. Instead, we lost "only" 54 thousand jobs. Additionally, we learned that June and July were not as bad as we thought. About 122 thousand jobs were NOT lost during those months! Things appear to be better than we thought?

More good news is that average hourly earnings were up 0.3%, which was more than expected, exceeding last month's 0.2%. This may also explain the higher-than-expected retail sales announced this week.

While the official unemployment rate went up to 9.6% from 9.5%. But, even that was a good thing, because 551 thousand workers re-entered the workforce, which is a good indicator that individuals have again become hopeful of finding a job and for good reason, since the private sector added 67 thousand jobs last month.

A lot of economic heart-burn got better at 8:30AM this morning!

Did Anybody Notice?

In 1988, I took my daughter to Cozumel to scuba dive. While there, I spent some time on the beach reading a book whose name I no longer recall. What I do recall is its strident insistence that stock analysts pay much more attention to the "P/E Ratio" or Price-earnings ratio. This is a measure of how much investors are willing to pay for a company's earnings on a per-share basis. For example, if a company earns $1.50 per share, and the stock is selling for $15.00 per share, then we can say it has a P/E Ratio of 10 or 10X. When investors are feeling optimistic, they will pay more than $15 for a $1.50 of annual earnings. They might pay $16 or $17 a share or more.

The importance of this metric was originally pointed out by legendary analysts Benjamin Dodd & David Graham back in the 1930's. The author of the forgotten book in Cozumel emphasized it is The Most Important metric. The Media (and therefore everybody else) clearly believe the monthly jobs report is more important.

The P/E Ratio has fallen from 23.1X last September to only 14.9X now. This 35% drop is the sharpest since 2003. What this tells me is that, absent some strong external shock, The Market is currently over-sold, which means it is more likely to go up . . . or even just bump-along . . . than it is to go down.

The Way It Should Be!

Late last night, I returned from board meetings in Chicago of the National Association of Personal Financial Advisors (NAPFA). Like any board of any national organization, they were grappling with all the normal issues, such as budgets during the tough times. But, no matter the issue, the focus always remained on what was both fair and best for "people". Occasionally, someone would use the word "client" or "customer" or even "investing public" but rarely. It was reassuring, comforting, and a little surprising to see such a collective sense of duty to "people"!

Unlike the Financial Planning Association (FPA), which is dominated by salesmen for insurance companies, and unlike the Investment Management Consultants Association (IMCA), which is dominated by salesmen for brokerage firms, NAPFA is dominated by servants of the fiduciary standard, that we must always act in the best interests of "people"! Our mission is not to sell products to customers but to actually serve their best interests.

I am proud to also serve NAPFA . . .