Breaking news - Paulson's bail-out plan in danger

See this vital article in today's Daily Mash.

"It's all the fault of Big Soup, I tell you!" Priceless.

Bond Is Back - iShares Euro Government Bond 15-30 (IBGL)

Something to do while collecting your IBGL dividends

So, what to do with the profits realised from last week’s sale of FXP?

Well, I have already invested some in a small contrarian play on Titanium Metals Corporation (TIE), but, most have now gone on adding to my position in the iShares Euro Government Bond 15-30 ETF (IBGL), taking advantage of lower prices to average down to £116.96 per share. I still think that deflation is a likely winner in the short term, and thus my original bond argument still stands.

Note that there is no sign of the euro-zone following the US lead in producing a bail-out package.

Contrarian Investing – Titanium Metals Corporation (TIE)

Titanium

So, after yesterday’s review of Gallea and Patalon’s book, how does their contrarian method work in practice? And, is it worth following today?

I think that it is, simply because the ongoing effect of the Credit Crunch on markets will be increased volatility. These will be stock-picker’s markets, where individual shares may actually do very well – at least for a while. And, I believe that Gallea and Patalon’s method has at least a fair chance of identifying oversold stocks that can bounce back strongly. So, let’s work through the method in a practical manner and see if we can come up with anything worth buying.

(1) Screen for stocks down in price at least 50% from their 52-week high. The easiest way to do this (for US shares) is to use Yahoo Finance’s Stock Screener, which is great as it is free to use. Sadly, Yahoo Finance UK doesn’t offer anything similar, but let’s stick to the US for now, as Gallea and Patalon’s work is all US-based. Building a screen is easy – select the following:

“Current Price Less Than 52 Wk High(%)” from Criteria, “>=” from Conditions, and “50” from Values

“Market Cap” from Criteria, “>=” from Conditions, and “250M” from Values (allowing for inflation from Gallea and Patalon’s $150M minimum cap criterion)

“Current Price” from Criteria, “>=” from Conditions, and “5” from Values

Set Return Top to 200 matches, and run the screen. I think you’ll find it’s something of a “target-rich environment” at the moment. Click on the Market Cap column to sort by descending market capitalisation (bigger is better), then export the results to a new Yahoo portfolio (you’ll need to create a Yahoo id to be able to do this), or a spreadsheet (or, just print out the list).

(2) Look for insider purchases. This is Gallea and Patalon’s favourite buy signal. While they do also recommend a number of value-orientated ratios, we’re going to stick with this one: cash purchases of at least $120K by insiders (or, knowledgeable outsiders, e.g., Buffett) in the past six months and no sales.

In fact, I’m going to add one more criterion: I want to see purchases sometime in the past week, i.e., since the Lehman collapse. I want to see insiders who are SO confident about their company that they’ll buy in size in the face of the most awesome market turmoil since the barbarians sacked Rome, as reports would have you believe.

Good old Yahoo – if you click on the stock ticker, you’ll see a summary page of information, while on the left-hand side there is another link labeled Insider Transactions. This gives you a nice tabular summery of insider purchases and sales for the past six months (US stocks only – the information is not available for ADR’s traded on US markets). For example, looking at Citigroup (C), the largest US company on my list, we see that there were 1,200 insider shares purchases over the past six months, and 100,000 sales. I think we’ll pass on the “Citi that never sleeps”, then.

On the right-hand side of Insider Transactions screen, you’ll note there is a field marked Get Insider Transactions for:, where you can enter the stock ticker of each of the stocks in the contrarian screen above. Now, this does involve a bit of donkey-work, but, given that Yahoo summarises what you need to know so neatly, it really doesn’t take too long. I managed to work my way through the list of 200 in about half an hour.

Now, there may be quicker ways of getting to the same information – there are numerous sites that offer alert services re insider transactions, say, and you could then look to see if the share price was down 50%. But, the great advantage of Yahoo is that it is free, and you get loads of other information to hand as well.

Anyway, to save you the effort, I only came up with one possible pick from my list of 200: Titanium Metals Corporation (TIE.NYSE), a producer of (surprise!) titanium melted and mill products. What’s interesting is that an officer, Harold C Simmons, stumped up $2.65M on the 15th of September to buy 250,000 shares. And, he’s not alone – other insiders have also spent significant sums over the past six months, buying a total of 481,076 shares, with no sales.

So, what more do you need to know? Well, TIE is a substantial company, an S&P500 member with a $2.2B market cap, that’s been around since 1950. Their markets include the commercial aerospace and military, chemical process, oil and gas, consumer, sporting goods, automotive, and power generation sectors. The valuation ratios are not particularly compelling, with the exception of P/E and PEG, viz.:

Trailing P/E : 11.07
Price/Sales : 1.86
Price/Book : 1.89
PEG ratio : 0.83

Source: Yahoo Finance.

So, it’s a shallow value play, at best, but certainly a contrarian play, as the price is well down from the 52 week high of $36.50. It’s certainly possible for corporate insiders to be wrong, and Faber’s “vicious economic downturn” doesn’t seem like the best of scenarios for a member of the Basic Materials Index.

On the other hand, who knows what fat military contracts they may pick up, which are more-or-less immune from an economic downturn? I’m speculating here, of course, and the last thing I want to do is over-analyse: you either follow a method or you do not, and contrarian investing is about nothing if not buying when “the blood is in the streets”.

So, I made a small investment in TIE yesterday at $12.35. As Gallea and Patalon recommend, I’m using a strict 25% stop-loss, and am looking to sell after a 50% gain or in three years, whichever comes first. I must stress that this is a risky play, suitable only for a minimal-sized investment; Gallea and Patalon recommend a large portfolio of contrarian stocks, as not all will work out.

I’d say TIE is even better value at yesterday’s closing price of $12.17.

Book Review - Contrarian Investing

Time to take a break from the day-to-day market action, and a quick review of an oldie-but-goodie, Contrarian Investing, by Anthony M. Gallea and William Patalon III (Prentice Hall, 1998).

This is a “how to” book, aimed at the private investor, describing the authors’ definition of what contrarian investing is, why it’s a good idea, and a practical strategy for actually investing in contrarian shares. Along the way, they also cover market manias, technical analysis, value-orientated fundamentals, risk and portfolio analysis and investor psychology, rounding it all off with a concise chapter summarising their contrarian investing rules.

I like this book a lot, especially because it focuses on contrarian rather than value investing. These two definitions are often confused; while similar, there is a fundamental difference in approach:

• Value investing starts by looking for assets with low fundamental valuations, in terms of price-to-book, price-to-earnings, or some other financial ratio, in the expectation that regression to the mean will eventually lift these assets back towards average valuations.
  
• Contrarian investing starts by looking for assets which the market currently despises, and then tries to find a reason for these valuations to improve.
  

Thus, Gallea and Patalon’s method starts with an initial technical screen, looking at a universe of stocks down at least 50% from their 52-week high. Now, in practice, Gallea and Patalon’s method will often identify the same “picks” as a pure value-investing screen, but the distinction is important.

I am also impressed by their chapters on risk management and investor psychology – too few books and information services aimed at private investors stress the pivotal role of risk and portfolio diversification. These areas are, in my opinion, far most important factors than stock-picking, and Gallea and Patalon offer a commodity trader’s perspective on risk management that is spot-on.

Of course, it is possible to criticise. The core of the book is Gallea and Patalon’s contrarian trading method, which is laid out logically and precisely, but which is not back-tested with any historical data. While they do point out the academic evidence to support each of the individual rules (such as the insider buy signal, or the power of low p/e’s), there is no back-testing of the overall method, and its applicability under different market conditions. Also, their method applies only to shares; despite touching on other asset markets, they give no indication how the method might be adapted to trading in commodities, bonds, etc.

But, overall, as I have said, I really like this book, and would recommend it to all private investors, even if you don’t take on board the authors’ contrarian method. Unfortunately, Contrarian Investing has been out-of-print for some time, but used copies are readily (and cheaply!) available from Amazon, viz.: Gallea and Patalon

A week is a long time in the markets

The colossal forces of inflation and deflation battle for domination

Well, this week was, anyway. Was it really only a week ago that Lehman went bust?

To my mind, the most amazing result of the last week is that the S&P500 (the most important stock index in the world) actually closed UP on Friday, compared to the previous Friday’s close – at 1,255 vs. 1,251.

So, was that it, then? Have Bush, Paulson, Bernanke and co. really saved the world with their $700B rescue plan?

Well, maybe. Friday’s markets seem to indicate that salvation is at hand, but we need to ask the following questions:

• Will the plan actually be approved? Congress has to pass it, and some people are trying to add-on their favourite clauses (the usual horse-trading), while others are speaking out against such a huge taxpayer bail-out. On balance, though, I’m inclined to think that it will go through, simply because the government has to be seen to be doing something.
  
• Can the plan actually be implemented? $700B is a lot of money, even for the USA. While the Fed can always print money, the effects on the dollar and the US credit rating may be severe.
  
• Is it enough? The devil is in the details – will the government buy this toxic debt at book value, or at some written-down measure? If the latter, the banks’ balance sheets will remain weak for years to come, which will keep the Credit Crunch … well … crunching.
  
• Are worse horrors to come? I’m thinking here of a blow-up in the credit derivatives market, which the failure of AIG threatened. The credit derivatives market is worth $62 trillion – too much, surely, for even Uncle Sam to buy up. The best article I have read all week is this one from Daniel R. Amerman. Be afraid – be very afraid.
  

So, it’s proceed cautiously, as far as I am concerned. The immediate inflation/deflation trade-off is the issue which most concerns me – monster bail-outs spell doom for the US dollar, so is my Powershares DB US Dollar Index Bullish Fund trade still valid?

Staying long for now.

He loves only gold

“Mr Bond, all my life I have been in love. I have been in love with gold. I love its colour, its brilliance, its divine heaviness. I love the texture of gold, that soft sliminess that I have leant to gauge so accurately by touch that I can estimate the fineness of a bar to within one carat” – Ian Fleming, Goldfinger

Looks like we’ve now had a more substantial bounce, based largely on hopes of US government action to “magic away” all the banks’ toxic debt.

Will it last? I have no idea, but I do think there is at least a least the possibility of a substantial bear market rally. Remember that this all comes down to the ongoing battle between the forces of deflation and inflation: while the Credit Crunch itself is fundamentally deflationary, the actions of governments and central banks to fight it are highly inflationary.

The CCI portfolio is currently deflation-orientated: while we have taken profits on our short-China play (FXP), both UUP and IBGL are plays on, respectively, a rising US dollar and falling euro-zone short-term interest rates. It’s time to hedge our exposure with something more inflation-orientated.

I’ll make an admission here. I’ve been long gold for a very long time, almost since the time Our Glorious Leader, Comrade Brown, sold off half of Britain’s gold reserves at a rock-bottom price. I believe in Bill Fleckenstein’s mantra (In a social democracy with a fiat currency, all roads lead to inflation), view the current monetary system as essentially a colossal fraud, and so am naturally inclined to see gold bullion as the bedrock of any portfolio.

BUT (and it’s a big but) I am also aware that, at least in dollar terms, gold suffered a twenty year bear market from 1980-2000, and that the post-2000 gold bull is, perhaps, getting a little long in the tooth. And, of course, I am very aware of gold’s precipitous sell-off from August this year, taking it down from over $950 to around $730 per ounce on September 11th. We’ve had a nice bounce since then, but does that make gold a buy now at $828 (as I write)?

Well, I’m personally not buying any more, but that’s because I’ve already got stacks of the stuff. Plus, I’m still sticking with the deflation followed by inflation thesis for now, although I am monitoring the situation closely and (unlike some other commentators) am certainly prepared to alter my opinion if the facts change.

However, if you are underweight, then I’d say gold is most certainly a “buy” right now, simply because I do not believe that the real gold bull market has even started yet, and any further dips in price that may happen will prove temporary and minor in comparison to the eventual gains. Why so?

Gold has gone up a lot since the 1999 nadir – almost four times to the peak at $1000 earlier this year. But, compared to other commodities, gold has been a mediocre performer – oil, for instance, went up by more than ten times over the same period. Copper, zinc, lead, molybdenum, uranium – all have outperformed gold.

So, why has gold been the “weak sister”? Well, it’s perfectly understandable if you regard gold as simply a “barbarous relic”, and a commodity like any other. Gold, as a material, is much less useful than all the other commodities listed above. Apart from filling teeth and adorning gangsta rappers’ necks, exactly what use is gold?

Emm … well, you can expend a tremendous amount of effort digging it out of the ground, then make it into bars and bury it again in an underground vault. Exactly.

Gold is money. At least, it used to be, before the impact of wars and vastly increased social spending made it inconvenient for the governments of the world. Since 1944, and even more since 1973, the role of gold as the underlying value behind the world’s money has been replaced by the US dollar, which is backed by … well, a lot of hot air, when it comes down to it.

And, where are we now? In the midst of the mother of all financial crises, centred on the USA, the only solution to which will be (in one form or other) massive money printing and currency debasement by the US government.

So, the reason to hold gold is because it is a store of value, perhaps (in future) the only reliable store of value that is no one else’s liability. Now, it may well be that the euro, or even the renminbi, eventually rises up to take over the dollar’s place at the centre of the world economy. But, there’s no guarantee of that (they’re only backed by hot air as well) and, in the interim, it is likely that increasing numbers of panicked investors will park at least a fraction of their portfolios in gold.

So, how to buy? Well, you can head down to your local coin shop, and there are online alternative like Goldmoney, but let’s assume you want an easy way to do it through your share dealing account. The one I hold lots of is the Lyxor Gold Bullion Security (GBS.LSE), which is backed by allocated gold bars held in HSBC’s vaults in London. Each GBS represents one tenth of an ounce, and the price as I write is $81.38.

The only problem with GBS is that, for some obscure reason, you are not allowed to hold them in an ISA or Child Trust Fund (GBS in a SIPP is fine). There are alternatives – one that I have held in the past (and is definitely ok for an ISA or CTF) is the Toronto and Amex-listed Central Fund of Canada (CEF-A.TO or CEF.AMEX), which also includes silver in its vaults.

Think of gold as insurance.

FXP – Locking In Profit

It’s been a wild ride for Asian markets today, initial falls were stymied by the Fed’s $180B liquidity injection. The stop I set on the Proshares Ultrashort FTSE/Xinhua China 25 (FXP.AMEX) has been hit, getting me out at $124.16. That’s not a bad result for 8 days investing (a profit of about 25% in dollar terms, although only about 20% in sterling). I expect this is a trade I shall revisit once things have calmed down.

The Lehman Disaster – Day 4

On Wall Street, employees brace for next disaster

Right, short-covering over, and yesterday was another black day for shares, with the S&P500 down about 4.46% and the FTSE 2.25% (although, up this morning, probably driven by the Lloyds/HBOS deal).

As per yesterday, a quick portfolio review is in order:

• Proshares Ultrashort FTSE/Xinhua China 25 (FXP.AMEX) – up big style yesterday, from $133.51 to $144.00. The 14-day RSI now stands at 76.52, which puts it in over-bought territory, but I suspect we will see more gains today. Nonetheless, we have seen excellent gains on this play in only a week, and I’d like to lock those in – so, I’m setting a stop-loss at $128.44 (just below yesterday’s low).
  
• iShares Euro Government Bond 15-30 (IBGL.LSE) – this actually fell yesterday, and is down again today to £117.25. According to Bloomberg, this is because of additional central bank liquidity pumping. I stick by my original analysis, and would still rate IBGL a buy.
  
• Powershares DB US Dollar Index Bullish Fund (UUP.AMEX) – down from $24.40 to $23.93, as dollar bulls get the jitters. Well, I’m sticking with the deflation argument for now, and my view of sterling has certainly worsened in the past day (just how much has the Lloyds/HBOS deal been underwritten by “my old mate, the U.K. taxpayer”, to paraphrase Sir Les Patterson?). So, another “buy” for me.
  

Of potentially great significance yesterday was the rise in gold, which posted its biggest ever one-day gain. Now, I’m sure I’ll have more to say on this matter, but, for now, I’ll just let Tony and the boys sum it up.

The Lehman Disaster – Day 3

“Pour encourager les autres” – the execution of Admiral Lehman

I never intended this to be a daily blog, but current financial events are so momentous as to demand it.

On Monday, I posed the question “why hasn’t the Fed and/or US government … bailed Lehman out?”

Well, now we know – because they needed to save insurers AIG, who really are “too big to fail”. Politically, questions were bound to be asked if the authorities bailed out all of “their rich pals on Wall Street”, and markets would get jittery over the dollar again, so somewhere a line had to be drawn. Maybe Bernanke just flipped a coin – “heads I save Lehman, tails it’s AIG”, then another flip for “heads I cut interest rates, tails I provide $70B emergency market liquidity”.

Back in Blighty, we see good old HBOS (said by the FSA to have a strong capital base and “continued to fund very satisfactorily”) forced into a rushed marriage with Lloyds-TSB. As a man in the pub informed me last night (always a reliable source :-) the sight of Mervyn King visiting Number 10 with a red folder meant that something was afoot. I can see a shotgun in the hands of the U.K. authorities behind this one.

So, what now? As before, the key question is whether these events are likely to have deflationary or inflationary consequences. Predictably, we had a short-covering rally on Wall Street yesterday, and something similar going on in London this morning. While it’s impossible to know for sure, my money is still in the deflationary camp, simply because the authorities’ actions to date have at best been stabilising (they’ve saved some big financial firms but not all of them, and interest rates remain on hold), and confidence is bound to remain weak. Plus, the true extent of the monetary destruction caused by Lehman’s failure will not be known until all of the positions are forensically unwound, and that will take months.

Nonetheless, I am mindful of Faber’s bounce expectations, so let’s review the CCI portfolio.

• Proshares Ultrashort FTSE/Xinhua China 25 (FXP.AMEX) – this fell yesterday, as markets rebounded, edging away from the near-overbought condition and bringing the 14-day RSI down to 65.49. Given that the Hong Kong’s Hang Seng index fell overnight, I am happy to hold for now, without a stop-loss.
• iShares Euro Government Bond 15-30 (IBGL.LSE) remains at £118.55. Hold.
• Powershares DB US Dollar Index Bullish Fund (UUP.AMEX) rose from $24.11 to $24.46, clearly reacting to disappointed expectations of a Fed rate cut. Again, a hold for me.

The Lehman Disaster – Day 2

Just a quick update from yesterday – was I right in expecting further deflationary pressure, and that the CCI portfolio looked fine?

Well, world stock markets certainly fell, which helped CCI’s Proshares Ultrashort FTSE/Xinhua China 25 (FXP.AMEX) to rise, going from $103.10 (at close Friday) to $117.69. Our long-dated euro government bond pick (IBGL.LSE) didn’t do anything yesterday, but as I write is up from £117.96 to £118.55. So, profits as expected there.

What is interesting (as in, the old Chinese curse, “may you live in interesting times”) is that the dollar had a dreadful day yesterday. Our Powershares DB US Dollar Index Bullish Fund (UUP.AMEX) fell from $24.33 (at close Friday) to $24.11; not a dramatic move, but the intraday low was $23.79, making for a long negative bar on the daily chart. To my mind, this indicates an ongoing mental struggle (in the minds of forex traders) as to whether yesterday’s events will ultimately prove deflationary (collapsing asset markets, lenders ever more reluctant, $70B rescue fund, dollar safe haven, etc.) or inflationary (central banks’ money market activities, possible rate cuts, Fed being forced to bail out AIG, etc.).

I’m sticking to the deflation camp, for the moment. No emergency rate cuts have yet been forthcoming (from the Fed, ECB or MPC), and, while I don’t have any hard figures, I find it hard to believe that the limited central bank actions so far will compensate for the huge sucking sound that is Lehman’s positions being unwound and written off. So, my money’s on an intensified US recession, a falling US trade deficit and a rising dollar, at least until the next disaster.

Interestingly, Dr Marc Faber (ever the contrarian) sees some kind of interim bottom in sight: "I would expect markets to temporarily bottom out between now and the middle of October and then have a fairly strong rebound, but of course, no new highs".

So, it’s certainly worth keeping a close eye on any short positions. As far as our China short is concerned, remember that FXP is a geared short play, so will lose money exponentially if/when the underlying index starts to rise. The 14-day RSI on FXP is 69.21, which is approaching over-bought territory (usually defined as 70+). So, it may be worth considering a fairly tight stop-loss soon. I’ll think about it.

The Lehman Disaster

Pity poor George Soros. "Over the three-month period ended June 30, he doubled the size of his firm's stake in Lehman to 9 million shares".

Can’t win ‘em all, eh George? Somewhere, I suspect that John Major and Norman Lamont may be enjoying a small celebration.

Now, the fact that Lehman was in trouble is not exactly news – the vultures have been circling for a while. What is remarkable is that Lehman has not, after all, proven to be “too big to fail” – they really have declared bankruptcy, after a frantic weekend trying to shore together some kind of deal. Why has it ended in Chapter 11, and what are the implications?

Firstly, let’s put this affair into perspective. Lehman Brothers was founded in 1850, and has been part of the Wall Street elite ever since – a definite “bulge bracket” member. This is not the First Appalachian Savings and Loan shutting up shop; this is a key component of the global financial system. So, I think that my graphic above is appropriate.

So, why hasn’t the Fed and/or US government done what they do best, and bailed Lehman out? Well, after Bear Sterns back in March (bought by JP Morgan, but in a deal only made possible by Fed’s non-recourse loan), and the monster Fannie and Freddie bail-outs only last week, it seems as though enough is enough. Tellingly, it appears that Barclays was up for the JP Morgan role, but had to walk away because “it was unable to obtain guarantees - from either the Treasury/Fed or other commercial organisations involved in the rescue attempt - in relation to financial commitments faced by Lehman when markets open tomorrow”.

So, is the Fed cupboard bare, then, when it comes to financing further rescue attempts? Well, no and yes, if I may put it like that.

“No”, because in a social democracy with a fiat money system and immense state power, the cupboard will never be bare. As Ben Bernanke is once said to have remarked, “We have a technology called a printing press” – if they were really inclined, the US government could simply create dollars as necessary to bail out Lehman.

“Yes”, because of the consequences of doing the above. Yet more bail-outs could cause a renewed collapse in the dollar, spiralling inflation, global dumping of US Treasury bonds, and a lot of domestic political flak – “the Republican party bailing out its rich friends, again”, with the election only weeks away.

So, to my mind, Lehman was allowed to fail, pour encourager les autres (as Voltaire referred to Admiral Byng). Time for a spot of moral hazard to bite you in the ass, guys.

So, what are the implications? Well, in the first instance, this is clearly another deflationary event. It will hit confidence once more, and the unwinding of Lehman’s obligations will result in further liquidity contraction. Then, there is the matter of the $70B emergency fund being put together by the (remaining) top banks – that’s $70B which will be unavailable for lending or speculative investment.

On the other hand, there are liquidity easing actions underway by all three main central banks.

Who knows, maybe we’ll even see a Fed emergency rate cut?

So, looking at the CCI portfolio, it’s steady as she goes, but keep a close watch!

Best of Bond

Come in, Mr Bond, we’ve been expecting you

I think that we have established by now that the Credit Crunch is a fundamentally deflationary event. Now, I don’t always expect to be picking pure deflation plays – indeed, I fully expect the end-game to the current crisis to involve massive inflation, and will eventually be making moves in that direction.

In the interests of being timely, however, I expect the next six months at least to be highly deflationary, and believe that finding investments which will prosper under conditions of contracting liquidity are the highest priority. With this in mind, we turn to the traditional safe haven in deflationary times – long-dated government bonds.

Why are long-dated government bonds considered such as a safe haven? Well, to put it simply, bonds issued by trusted governments set the standard for credit-worthiness. They are, by definition, “AAA”. To understand why, think for a second just what a long-dated leading government bond is - a promise, by a sovereign state, to do the following:

• To pay a fixed capital sum, in their own currency, on a certain date in the far future.
• Between now and then, to additionally pay a fixed coupon, on a regular basis, also in their own currency.
  

Now, there are of course variations on this theme – inflation-indexed bonds, short-dated bonds, bonds issued in other currencies, etc. But, for our purposes, what is attractive are the bonds fitting the above description, be they long-dated US Treasuries, UK Gilts, etc.

If you were to buy such a £1 bond “fresh” as it were, from the UK government, you would know that you would get your pound back in, say, 2040, and that every year between now and then you would collect coupons amounting to, say, 4.5p per annum. You therefore know that you will get a 4.5% yield on your investment, between now and 2040, with the absolute assurance that you would then get a full return of capital. Why do you have such an absolute assurance?

Well, it’s as near an absolute assurance as you are going to get in the world of investment (which is to say, not really assured at all, but we’ll come to that later). The reason why it can be considered an absolute assurance is because we live in an age of fiat currencies and immense government power: it makes absolutely no sense for a sovereign power to default on its debt (and so ruin its credit rating), when it can simply print up the banknotes to pay it off (and, herein lies the rub; as return of capital is only assured if you ignore the reduced purchasing power of a depreciated currency).

But, this is why long-dated government bonds are so attractive in a deflationary environment. Under deflation, assets like shares and property will be falling fast, but investors will still need something that pays a return on capital. Cash is no good, as governments everywhere will be manipulating short-term interest rates downward, hoping to kick-start a recovery. But long-dated government bonds should actually rise in value – remember that 4.5% yield in the example above? Now, 4.5% may seem pretty miserly when you initially bought the bond, but when short-term rates are slashed down to 1%, stocks are seeing dividends cancelled all over the place, and no one can afford the rent on your buy-to-let, suddenly 4.5% seems like a damn’ good return, especially as it is government-guaranteed for the next twenty-plus years. In fact, 3% might seem like a good return too, so enabling the secondary market price of your bond to rise from £1 (coupon 4.5p, yield 4.5%) to £1.50 (coupon still 4.5p, yield now 3%). Ta-da! Profiting from deflation, the easy way.

Ok, enough theory. Are long-dated government bonds a good buy now and, if so, which ones?

Can we expect continued deflationary pressure over the at least next six months? I believe the answer is yes, because (despite what governments will attempt), financial institutions are too bruised to resume lending at their previous pace. That implies a global recession, falling stock markets, and short-term interest rate cuts. So, who’s long-dated government bonds are the best buy?

I believe we can discount US.Treasuries. Remember, the Fed has already acted swiftly to cut short-term rates to only 2%. In addition, the portfolio already has a large dollar exposure, though the Powershares DB US Dollar Index Bullish Fund bought last week.

What about British Gilts? At 5%, short-term British rates have more scope to fall. But how soon will that happen? According to Reuters, "Bank of England Governor Mervyn King appeared in no hurry on Thursday to cut interest rates". Staying Mervyn’s hand is the plunging pound, and persistently high rates of inflation (officially between 4.4% and 5.3%, depending on which CPI or RPI version you prefer). And, the plunging pound is one more reason for us to look elsewhere.

Now, the ECB may be in no hurry to cut rates either, but I’m betting that the euro will remain consistently stronger than the pound, if only because there is at least an even chance Gordon Brown will try to save his skin with a huge Fannie and Freddie style mortgage bailout (which could only be financed through massive gilt issuance).

There may be other “AAA” long-dated government bonds that are a better buy (I’m thinking Switzerland, or maybe Singapore), but in practical terms there is no way for the small private investor to gain exposure to these (unless you buy a managed bond fund, but then who knows what the manager will choose to buy?).

For euro long-dated government bonds, there is a simple solution – yes, once more an ETF, this time the iShares Euro Government Bond 15-30 (symbol IBGL on the LSE), which “offers you exposure to a diversified basket of longer-term government bonds, with maturities ranging from 15 to 30 years”.

I bought a fair-sized chunk of these yesterday at the closing price of £117.96.

A Bear in China

Jim Rogers is a financial commentator for whom I have a great deal of respect. His latest book, A Bull On China, is subtitled Investing Profitably in the World’s Greatest Market. However, I must confess, I have not read it yet – simply because, I do not believe that the time is ripe.

The basic “21st century belongs to China” thesis is one I agree with, and, indeed, have profited handsomely from during 2002-2007. But, this is another long-term trend (allied, of course, to the long-term decline of the dollar), and not, I believe, the way to bet for at least the next few months.

I discussed briefly the nature of the Credit Crunch last week, and how the positive feedback loop of 2002-2007 (rising US credit driving rising US consumption driving rising US trade deficits) has now reversed. One of the prime beneficiaries of the Great Credit Bubble was, of course, the Chinese economy – China has become the “workshop of the world”, and you have to look hard to find household goods that are not manufactured in China nowadays. Even supposedly American products such as the Apple iPod are actually manufactured in China, as outsourcing has become a buzzword and western corporations become ever more “lean” and “focused” (i.e., concentrated on design, marketing and distribution, while leaving the messy business of actually making things to external suppliers).

Now, there are some good economic arguments supporting the outsourcing craze. Actual widgets, of whatever variety, are becoming increasingly commoditised, and product differentiation is often supplied by clever marketing and brand image. The higher margins are to be found in the non-manufacturing elements of the value chain, while outsourcing gives companies the flexibility to scale volumes up or down as required, without having to hire or fire workers. This last point is important, as, not only are western workers relatively expensive, but they also have those pesky labour laws and unions to offer them some protection from arbitrary dismissal. And, of course, there are myriad other inconveniences, such as health and safety laws, pension legislation, women’s rights, environmental restrictions, etc., etc. … all of which conspire to actually make employing someone in the west to bash bits of metal a most unattractive prospect.

In China, of course, there are none of these worries, such is the joy of totalitarian capitalism and a billion-strong population in need of employment. Hence, the dramatic growth in the Chinese economy, and the rapid appreciation in Chinese share prices, exemplified by the chart above.

But, of course, that was then and this is now. The flip side of all this Chinese manufacturing expansion during the good years is that it is now going into reverse. Easy to hire = easy to fire. And, there is a double multiplier effect:

1. The Chinese export boom has driven a massive domestic infrastructure boom, which will also now be hit by the Credit Crunch.
   
2. The global credit bubble has driven a bubble in Chinese shares, as western money flowed in search of the best returns (now retreating, as return of capital becomes more important than return on capital).
   

All of which means we can expect Chinese equities to actually perform worse than the US, despite the Credit Crunch originating in America.

The above chart shows the price history of an iShares ETF (symbol FXI on the NYSE; also trades as FXC in London), based on the FTSE/Xinhua China 25 index, an index of the leading 25 Chinese stocks listed on the Hong Kong Stock Exchange (and, thus, open to foreign investors). As you can see, the appreciation has been dramatic, especially from the start of 2006 until October 2007, rising from about $20 to over $70 – more than a triple! Since then, of course, the Credit Crunch has kicked in, and the price has come down to around $37 as I write – just about half. That’s a lot worse than the S&P500, which is “only” down about 20% on its October 2007 peak.

So, what now? You might expect any market which is down by half to stage a rebound, and, in the short term, you may be right. However, as I write, the 14-day Relative Strength Index (RSI – a technical measure) of FXI stands at 35, which is certainly not “oversold” territory (usually reckoned to be 20 or less). Also, the fundamentals of the FXI are far from cheap:

P/E ratio : 15.83
Price/Book ratio : 2.66
Dividend yield : 2.59%

(source http://www.proshares.com/funds/fxp.html?Index )

Again, note the above chart – at $37, the FXI is just about back where it was in April 2007, when the credit bubble was in full swing. No, I expect to see FXI down to around $15 or so before we’re finished, and likely within the next year, too.

How to profit from it, then? Well, as with last week’s posting, there are a number of ways, but my choice would be another Amex-traded ETF – the Proshares Ultrashort FTSE/Xinhua 25, which trades under the symbol FXP.

FXP is leveraged, so it gives you 200% of the inverse performance of the FXI. This, of course, increases the risk, as leverage works both ways (thus, if the FXI starts appreciating, FXP will decline at twice the rate). In the interests of disclosure, I should point out that I’ve had these for a while, and am well into profit already, but I would still buy them today at $99.55 (about £56.58). While I wouldn’t buy as many as the UUP dollar play last week, this is still a play worth making in size.

Credit Crunch Theme Song

Seems appropriate.

Dollar Bull

US Dollar Index, monthly candlesticks, 2002 - 2008

http://www.tradingeconomics.com/Economics/Currency.aspx?Symbol=USD

“A vicious economic downturn is about to unfold”
Dr Marc Faber, August 20th, 2008 (quoted on Howestreet)

The first use of the term “credit crunch”, as it relates to our present difficulties, that I have been able to find is from an AFX News feed of 11th July, 2007:

London shares are seen opening lower this morning with trading expected to be volatile amid fears of a possible global credit crunch, sparked by the crisis in the US mortgage market

Well, we all know that, in the succeeding 13 months, it’s been a lot more than “possible”. And, as the above article indicates, the origin of the global credit crunch lies in the US mortgage market crisis, which has since spread to US and world stock markets, and now the “real” global economies.

So, why have a bunch of sub-prime home loans to American NINJA’s (No Income No Job Applicants) caused such problems? Well, to put it simply, because the massive credit expansion associated with the US residential property boom was the engine which drove the world economy for the preceding five years. While the seeds of the current bust lie in the preceding boom, the seeds of that preceding boom lie in the bust just before: the dot-com crash of 2000-2002.

The effects of that crash spooked the Fed into reducing interest rates to the unprecedented low of 1%, and keeping them there for a full year (2003-2004). Depending on how you calculate inflation, a 1% interest rate actually paid people to borrow, and encouraged the massive property speculation bubble to form. With rising house prices, low interest rates, and rising financial ingenuity, there was also a strong incentive for people to re-mortgage their existing homes, and use the money for consumption.

Rising US consumer spending translated into rising US trade and current account deficits, as global manufacturing has increasingly shifted to the Far East. These deficits, in turn, helped to sustain a feed-back loop of rising US indebtedness, rising foreign dollar reserves, rising commodity prices, and a falling dollar. Just look at the chart above, showing the US Dollar Index from 2002 to 2008 (the US Dollar Index is an index of the United States dollar relative to a basket of foreign currencies - the Euro (57.6%), Japanese yen (13.6%), Pound sterling (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%) and Swiss franc (3.6%)). From a high of over 100, it’s been downhill all the way to the low seventies this summer.

So, what now? The key point to remember is that this crisis started in America, and, for quite some time, there was an expectation (hope?) that it might stay there. Thus, while the Fed reacted swiftly to cut interest rates again (going from a post-2002 peak of 5.25% last August to 3% in January, and then 2% in April), both the ECB and Bank of England moved more cautiously. UK rates have only come down from 5.75% to 5% over the same period, while the ECB actually raised their rate from 4% to 4.25% in July.

Now, these rate disparities may certainly have helped to drive the dollar index down to its low point this July, but what’s interesting is that the last two monthly candlesticks indicate a rising dollar index, with the August value rising quite sharply. Does this make any sense?

Well, yes, it does, if you think about the credit crunch as essentially the opposite of the preceding five years. The feedback loop referred to above has reversed: what we have now is falling US indebtedness (as lending has dried up), falling foreign dollar reserves (as the US consumer buys less from abroad), falling commodity prices, and … a stronger US dollar.

Only now is it becoming apparent that the US trade and current account deficit, the engine of world growth from 2002-2007, is now shrinking. While the Asian and European economies will be hit hard by the drop in exports, economies like the U.K. are suffering more directly, as we can no longer sustain our own house-bubble party, now that the global securitised mortgage market is essentially dead. And, that means, sooner rather than later, that the ECB and the MPC will be forced to follow the Fed’s lead and cut interest rates.

So, that’s my thesis: that the recent rise in the dollar index will prove to be sustained, and is a symptom of the spreading global recession. Now, that’s not just my thesis – I refer you Dr Marc Faber’s comments reported on Moneynews.com, on 25th August:

"My view is that after four years of under-performance, the U.S. dollar would now outperform for three to six months. I still maintain that," Faber says. "I think the dollar can continue to rally somewhat to $1.47 against the euro"

Now, like Faber, I am no long-term fan of the US dollar. I actually believe that we are seeing the beginning of the end of US global hegemony, and, with it, the end of the central place of the dollar as the world’s reserve currency. But, that’s a long-term trend; I’m looking here for a trade that will make money over the next few months. And, what I see happening for the next six months or so is a continued tightening of liquidity, a worsening recession, and the ECB and MPC being forced to cut interest rates quite aggressively. The outside chance of a complete breakdown in the euro should also not be dismissed, under the strain of rising unemployment and financial crisis.

Now, if you ask me to peer into my crystal ball a little further, I’d say what lies beyond that is still further Fed easing, and maybe Ben Bernanke finally getting his proverbial helicopter out (to drop money from the sky). At that point, you’ll see renewed dollar weakness, and you won’t want to be in this trade any more. But, this is speculation through a glass, darkly.

So, in practical terms, how to profit from this trend? Well, the most obvious way would be to simply open a USD bank account, and park your spare cash there. Alternately, you could look for more leverage by using futures or options, or even covered warrants or spread bets.

However, none of these methods are much use if your portfolio is parked inside an ISA, and the more leveraged versions also rely on you getting the timing pretty much right. To my mind, the easiest way to play a rising dollar is through an Exchange Traded Fund (ETF), specifically the Powershares DB US Dollar Index Bullish Fund (see Proshares website), which trades under the symbol UUP on Amex. Any half-decent discount broker should be able to trade on Amex (the American Stock Exchange, confusingly the junior brother of the much larger New York Stock Exchange, the NYSE), and, as UUP is a share, it can be held in a SIPP, ISA or Child Trust Fund without any problems.

I bought a big chunk of these last week at $23.74; they’re now $24.34 (about £13.83), and I’d still buy today.

Why Be A Credit Crunch Investor?

Economy at 60-year low, says Darling. And it will get worse

Britain is facing "arguably the worst" economic downturn in 60 years which will be "more profound and long-lasting" than people had expected, Alistair Darling, the chancellor, tells the Guardian today.

Now, I’m not a great one for trusting politicians – especially not the debased bunch of shysters running the U.K. at present. But, when they are in government, one thing you can usually count on them to do is to paint as rosy a picture as possible. You know how it goes …“no more boom and bust” … “longest period of sustained growth in [however many] years” ... “economy is robust” … “prudence” … etc. … etc. …

So, when the chancellor of the exchequer goes on record as saying that we may face the worst economic downturn in 60 years, you know that we are, in the immortal words of The Daily Mash, “Well F*cked” Why, then, do I think it’s time to start investing?

Because you have no choice.

That’s not quite true, of course – you always have a choice. You can choose, for example, to not have any spare cash at all (although it may not seem like much of a choice – “Yeah, I want to live in poverty!”). Or, you can choose to pay off any existing debts that you may have (a very wise choice, in my opinion). Best of all, you can choose the ... emm ... Best option:

I spent a lot of money on booze, birds and fast cars. The rest I just squandered.
George Best

But, let’s assume for sake of argument that you do have some spare cash, and that you are very keen to at least hold onto it. So, what do you do with it? For most risk-averse people, the answer would be “savings”, either in a piggy-bank beside their bed or (more likely) a nice, safe little bank or building society account somewhere.

I’ve got news for you people. You’ve just made an investment, whether you like it or not. And, like every investment, it carries risks.

Money in the bank - what could be risky about that? Well, unless you are one of tiny minority with a safety deposit box and your own key, you don’t have money in the bank. Do you really think that your local branch has an old shoe-box somewhere in their vault, with your name scribbled on the front and a grubby roll of fivers inside?

No, that’s not how it works. When you give a bank your money, you no longer have the money. It’s theirs now, to do with as they see fit – mainly, to lend out to the first conman who comes along, who’s credit profile happens to tick their boxes. All you have is a statement of liability (more commonly called a bank statement), which details exactly how much money the bank now owes you. Why might this be a problem?

Well, it’s not, usually, as long as everyone doesn’t ask for their money back at the same time. But, what about when they do, and most of it has already been lent out to one conman or another (what is known as “fractional reserve banking”)? Remember those queues outside Northern Rock?

Aha, you say, but that’s not much of a risk, as our good friend the U.K. taxpayer (in the shape of our ever-benevolent government) guarantees bank deposits up to £35K and, in practice (see Northern Rock again), will step in to shore up the balance sheet of any bank in danger of going under.

Leaving aside the issues of (a) what if you have more than £35K on deposit and (b) the hassle and delay of getting your deposit compensated, there is one HUMUNGOUS risk associated with investing in a “nice and safe” bank account (or a piggy bank beside your bed). Actually, to judge from history, it’s not so much a risk as a certainty. And, recent government actions such as the shoring up of Northern Rock simply make it all the more likely.

I refer you to an excellent paper from the Office of National statistics, entitled Consumer Price Inflation since 1750

To quote:

• between 1750 and 2003, prices rose by around 140 times
• most of the increase in prices has occurred since the Second World War: between 1750 and 1938, a period spanning nearly two centuries, prices rose by a little over three times; since then they have increased more than forty-fold.

Put another way, the index shows that one decimal penny in 1750 would have had greater purchasing power than one pound in 2003

For the U.K. resident, at least, the lesson of history is clear – stick your money in the bank and its real value will be eaten by inflation.

Who Is The Credit Crunch Investor?

I’m no one special. Just an ordinary private investor, with no special contacts, no magic systems, no professional investment background, and, certainly, no promises to make you or anyone else rich. I’ve started this blog, as much as anything else, as simply an extension to my own investment diary, where I keep scribbled notes of my trades, investing theories, and results.

So, why do I think I have anything worthwhile to say? Well, I have read a lot of books, both on the specifics of investment and on the world in general, and I like to think I occasionally come up with original insights (or, at least, correlations between other people’s original insights). And, I have “walked the walk”, by managing my own private portfolio for the past few years, with most satisfactory results (already I hear you say – “Aha! But the past few years have been easy – it’s making money now that’s the challenge”. I quite agree).

The overall ethos of this blog can be summarised by paraphrasing Marx:

The philosophers have only interpreted the world, in various ways; the point is, however, to profit from it.

So, I’ll be looking to come up with regular ideas and how to profit from them, from the perspective of a U.K. based small private investor. That means in practical terms – just because Cambodia, say, looks like the next hot frontier market, there really isn’t much point in thinking about it, as there is no way for the small investor to get a slice. However, my perspective is most assuredly global, and covers all manner of asset markets – shares, bond, etf’s, commodities, gold, silver, property, etc., etc. Just as long as there’s a way for the average person to get on board.

I’ll also have the odd bit of economic analysis, book reviews, theories, off-colour humour, and whatever else takes my fancy – this is a blog, after all. Hang around, you might like it.