Trends I'm Watching

China's Bad Loans

Trend: The problem of bad loans, and attempts to cover up the problem, threaten to undermine the economy in China and affect all institutions with loans in China.

Gary Halbert, president and CEO of the ProFutures companies, describes the reasons he recommends against investing in China in the next few years.

Link: InvestorsInsight : Forecasts & Trends

...there are no good options for China over the next several years. With their economy surging at 9-10% or higher per annum, China risks an inflationary spiral, and as we all know, that will not end pretty. On the other hand, if the Chinese authorities raise rates enough to slow down their red-hot economy, they could well face a banking and financial crisis. Either way, China faces a tough situation over the next few years!

While the Chinese authorities have taken baby steps toward slowing the economy slightly, such as the recent increase in the bank reserve requirement, it would appear that the authorities are not willing to slow the economy significantly to reduce the threat of inflation. With the political threat of a recession, and a possible banking crisis, the authorities appear willing to let the red-hot economy continue. This means the bad loan problem will only get worse.

... a major problem in China -- whether it be soaring inflation or a banking crisis -- will be very bad news for the US and the West.

...most of the major Western banks and financial institutions have large investments in China, some or many of which may be in non-performing or under-performing loans of various types. It remains to be seen how they will deal with the valuations of such loans in light of the recent reports from Ernst & Young, Price Waterhouse Coopers, McKinsey Global Institute and Fitch Ratings.

The bottom line is, the risks of investing in China now are very high in my opinion and that of Stratfor. Even BCA, which tends to be more optimistic, has closed out all of its clients' positions in the Chinese equity markets.

... there is certainly the possibility that the wheels could fall off of the "Chinese miracle." If that happens, the Chinese stock markets could go into a multi-year nosedive, much like we saw in Japan in the 1990s, or even worse. I also believe a meltdown in China could send the US and Western equity markets into a bear market as well.

Less Money Available Everywhere

Trend: Central banks, with Japan making the most aggressive moves, are using their power to reduce the amount of money available for loans and speculation.

John Mauldin describes how the actions of central banks can impact consumers and small investors.

Link: InvestorsInsight : Thoughts From The Frontline

The real culprit is one Mr. Fukui, who is the Governor of the Bank of Japan. While central bankers everywhere are in a struggle to prove their manliness by being harder on inflation than their peers, Mr. Fukui has shown to be the clear cut champion. They have taken massive amounts of liquidity out of the Japanese system in the past few months.

George Soros, commenting last week, brought home the point:

I think we are in a situation where almost all the asset classes will be under pressure or are under pressure and the main reason for that is the reduction in liquidity. What people do not realize is that the Japanese Central Bank has withdrawn something over $200 billion worth of excess liquidity from Japanese banks. Now that money was not put to work in Japan because there was no room for it, a lot of that went abroad, went into emerging markets, there was a so-called carry trade and it is not that suddenly people are risk averse. It is really that liquidity has been drawn out of the market and that is affecting emerging markets.

$200 billion in a global economy may not sound like a lot. But remember this was money in fractional reserve banks. They could easily multiply it several times. Pretty soon we could be talking a trillion dollars. Much of it went into providing cheap liquidity to global hedge funds and aggressive investors and banks. Thus, as the leverage went away, these groups started liquidating their very profitable emerging market trades, their commodity trades, and so forth. Everything began to go down at once. Markets that had not been historically correlated all of a sudden went down in tandem to the drumbeats of margin clerks everywhere.

For several years, speculators have been able to get very low interest rate money in a currency that was purposely being held down. It doesn't get any better than that. Low cost money encouraged speculation in every corner of the investment world. Not just stocks and commodities, but high yield and emerging market debt. The yen carry trade fueled the investment world.

Now Japan has said not only are we going to take massive amounts of money supply from the world, we are going to raise rates and allow the yen to rise. All that "free" money investors and businesses around the world borrowed is going away. It is going to become far less than free. By-by carry trade. Fukui indeed.

Between the central banks of the world almost universally tightening, commercial banks poised to tighten and the US housing market looking like it is going to slow as interest rates rise, it is very likely the US economy is going to slow down in the last half of the year. The question is, "How much?"

I do not think we will be in an actual recession by the end of the year. But a recession is not out of the question for 2007. If the Fed does not have to go too far (and 5.5% may be too far given the other conditions in the world), then we could see a slowdown on the order of what we saw in the mid-90's. We will have to watch the yield curve and other indicators.

In any event, whether it is slowdown or recession, I think investing in the broad stock market is particularly risky. If you are good at picking stocks and know the companies you are investing in, that is one thing. But most readers invest in mutual funds and broadly diversified stock portfolios. Bluntly, I think there is some real risk to the downside.

And if the US economy slows down, so will the housing market and so will the US consumer. That will be a drag on the world economy and world growth in consumption. If the world slows down too much, you could see oil drop back into the $50's or even $40s!

ProShares provide short exposure to market indexes

Trend: A new family of ETFs, providing short exposure to well-known market indexes, gives investors more flexibility to profit from corrections in the stock market.

ProShares is a subsidiary of the ProFunds Group, which manages ProFunds mutual funds, the nation's largest lineup of indexed mutual funds.

Link: ProShares.com: Homepage News

ProShares, together with The American Stock Exchange® (Amex®), today [June 21, 2006] announced the launch of eight new innovative exchange traded funds (ETFs) designed to make it easier for investors to get short or magnified exposure to an index.

Four Short ProShares are the first ETFs designed to provide short exposure to well-known market indexes, seeking daily investment results that correspond to the inverse of those indexes, before fees and expenses.  Four Ultra ProShares are the first ETFs designed to magnify daily index performance. They seek daily investment results that correspond to twice the performance of their underlying indexes, before fees and expenses.

The Amex® and ProShares also anticipate launching four UltraShort ProShares ETFs that will seek daily investment results that correspond to twice the inverse of their underlying indexes before fees and expenses. These ETFs are not yet available.

"We look at ProShares as the start of a whole new chapter in the development of ETFs," said Michael Sapir, CEO of ProShare Advisors, Inc., part of ProFunds Group. "By providing built-in short and magnified exposure to the indexes, ProShares make it much easier to execute a number of powerful strategies. In times like these, when the markets haven't necessarily offered a lot of help, we've seen investors interested in pursuing more sophisticated strategies—for example, hedging to manage risk. Now, to execute that strategy, they no longer have to go through the process of setting up margin accounts or covering margin calls—they can simply trade ProShares."

Names of ProShares, their objectives and ticker symbols:

Short ProShares

Fund Name	Daily Objective*	Ticker Symbol (NAV)
Short QQQ® ProShares	Inverse of the NASDAQ-100 Index®	PSQ
Short S&P500® ProShares	Inverse of the S&P 500® Index	SH
Short Dow30SM ProShares	Inverse of the Dow Jones Industrial AverageSM	DOG
Short MidCap400 ProShares	Inverse of the S&P MidCap 400	MYY

Ultra ProShares

Fund Name	Daily Objective*	Ticker Symbol (NAV)
Ultra QQQ ProShares	Double the NASDAQ-100 Index	QLD
Ultra S&P500 ProShares	Double the S&P 500 Index	SSO
Ultra Dow30 ProShares	Double the Dow Jones Industrial Average	DDM
Ultra MidCap400 ProShares	Double the S&P MidCap 400	MVV

Disclosure: I may own ProShares at any given time.

Market Drivers

Trend: Higher interest rates and decreasing mortgage equity withdrawal will gradually slow consumer spending in the near future.

Barry Ritholtz writes about the forces that have been driving the economy at The Big Picture blog.

Source: The Big Picture

...the prime driver of the 2002-05 recovery has been the Fed. They slashed interest rates to 46 year lows, bringing the Fed Funds rate down to 1%, while cranking up the printing presses. Then, they kept rates low for a long time. Cheap money sent all sorts of hard assets -- oil, gold, real estate, other commodities -- soaring. This stimulus -- and not tax cuts, as Rich Lowry incorrectly claims -- was the key driver of the economy. Hey, I like tax cuts as much as the next guy, and personally benefitted ALOT from the dividend tax rate of 15% (before the AMT got me). But I calls 'em as I sees 'em, and it was historically ULTRA-low interest rates, and not the marginal change in top rates, that have been the prime domestic engine. (China was a close second, with the weak dollar right behind it).

...Mortgage Equity Withdrawal -- has gotten recognition as it put trillions of dollars into the hands of consumers, where it has been transmogrified into SUVs, new Kitchens, and HDTV plasma screens.

The mechanism for how this plays out is less well understood by Wall Street and the general public,  and is slowly becoming accepted. It has begun to infiltrate the collective consciousness of investors. How the prime mechanism of the growth engine plays out, where its trending, and how it is likely to shift over time will be the key to if we ultimately end up with an economic soft landing, a hard landing, or an outright crash.

To get a sense of how important MEW is, look at what GDP would be like without it. (Pretty scary, huh?). The usage patterns of consumers is the key to understanding where this can go.

Here's where it gets tricky: Despite the rise in interest rates and the cooling of real estate, US Mortgage Equity withdrawal has remained robust.

Spending patterns following mortgage equity withdrawals. The extra MEW green in consumers pocket is typically spent over 2 to 3 quarters. That implies the $249B or so extracted in Q1 will be spent from then to Q3. If Q2 slows even more, that gets spent from then thru Q4, and so on.

Even as MEW slows, it will still be stimulative, albeit at a decreasing rate, for the foreseeable future.  This will continue until something stops the spending -- most likely, a sentiment panic that freezes consumers from spending, with a religous epiphany involving saving money (hard to even imagine tho that may be). 

I suspect that will occur slowly -- much later this year or early 2007. The market's action in May could even be the beginning of discounting that consumer slow down.   

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Mortgage Equity Extraction, components

Bottom line: Without something else to take the place of MEW, the consumer cannot drive the US economy at these levels for very much longer. Unless business spending ramps up dramatically, there is nothing else on the horizon to take the spending baton.

Why are markets falling?

Trend: Markets are falling as central banks address some tough, persistent economic realities.

John Mauldin offers some compelling reasons for the drop in equity markets: rising interest rates, rising inflation, and tough language from the central banks.

Source: InvestorsInsight : Thoughts From The Frontline

...here are the worst performing 20 markets through Thursday.

By contrast, the broad US markets have held up relatively well. The Dow is off around 6.4% from its high, which hardly qualifies as a decent correction, and the NASDAQ is down by 10%.

...In short, the central banks of the world are taking liquidity out of the system. It was the providing of massive amounts of liquidity that had driven asset prices around the world to frothy heights, and now we are seeing what happens when that process goes into reverse. It wasn't like we didn't have any warning. They made it very clear.

...Japan was the primary provider of cheap liquidity. It was a result of their desire to rid themselves of the demons of deflation. And now they apparently have.

...Is it any wonder that hedge funds are scrambling to find the exits?

...a now prescient paragraph from a speech by Alan Greenspan last August...."Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."

...We are watching risk premiums reassert themselves in markets around the world. This process is hardly over.

...Easy Al knew when to leave, and Gentle Ben has to pick up the pieces of what was a very long and very accommodative monetary policy, both here and in Japan. And in the case of the US, all the inflation that is now starting to show up was created on Easy Al's watch.

...inflation, in the things that really matter to you and me, is very much present.

...For the last 30 years, new Fed chairmen (Miller, Volcker, Greenspan) have felt the need to prove their mettle. And it has resulted in a lower stock market. It looks like this time will be no exception.

Can governments continue to postpone facing reality?

Trend: Stock and bond markets are correcting as the central banks try to reverse the effects of excessive government and consumer spending.

Jim Jubak at MSN Money describes the tough decisions that central banks must make to compensate for bad government policies.

Source: Can bankers save the world? Investors say no - MSN Money

The simultaneous global meltdown in stock and bond markets from Bombay to New York is a vote of no confidence in the world's central bankers. Central banks everywhere are facing huge challenges. By selling shares and bonds for most of May, investors and traders said loudly and clearly that they don't think bankers are up to the job.

The details vary from country to country, but the problem is the same: Over the last decade or more, the world's central banks have made a bad bargain with governments that collect taxes and then spend the tax receipts plus borrowed funds. Rather than letting the irresponsible fiscal policies of governments from Beijing to Washington damage national economies, the central banks decided to use their control of the money supply to postpone the consequences of fiscal folly.

Now the bill is coming due, and, although the central banks still think they can put off paying the bill for past behavior, investors are less and less certain. Some days, in fact, they get positively panicky.

Let's start with a look at the U.S. Federal Reserve because it's most familiar and closest to home. The Fed decided to fight the effects of the stock market bubble burst of 2000 by taking interest rates down to 1%. That created a real estate boom, which drove up housing prices, making us feel better in the United States about all the money we'd lost in the stock market crash. Interest rates of 1% also created a mortgage refinancing and home-equity lending boom as homeowners rushed to take some of that new equity out of their houses and spend it on a second home, a new car, a vacation, whatever. The resulting surge in consumer buying prevented the stock market crash from sending the general economy into the tank and gradually revived economic growth.

At some point, the Fed knew well, all that extra cash has to come back out of the economy.

Now taking excess liquidity out of an economy is never simple. And circumstances have combined to make it especially tricky for the Federal Reserve right now.

• First, this flood of liquidity wasn't the first time that Alan Greenspan's Federal Reserve had poured cash into the economy. It did the same to head off the Asian currency crisis, to avert the Russian debt crisis and to prepare for a Y2K crisis that never arrived. The Fed has never mopped up the cash left over from those rounds of crisis management. So, the post-stock bubble round of liquidity was like pumping more water into an already partially flooded basement.

• Second, for reasons that I still can't fathom, Greenspan told Washington politicians that the huge federal deficits that resulted when Congress passed the Bush tax cuts and massively increased spending weren't a big problem. That left the Fed using monetary policy to take cash out of the economy to slow growth and temper inflation while the Washington politicians were using fiscal policy to stimulate the economy.

• Third, the Federal Reserve wasn't the only source of abundant cheap money in the world. In Japan, for instance, short-term interest rates were even lower than in the United States as that country tried to end a decade of no growth and price deflation. This allowed international traders to borrow Japanese yen at 1% with 5-to-1 or higher leverage and then put the borrowed funds into Icelandic bonds, U.S. Treasuries, copper futures or Indian stocks, which pushed up asset prices around the world and created a number of mini-bubbles. (Some of those have been popped in the correction, but others still wait the application of the pin.)

No wonder then that U.S. bond and stock markets are worried that the Federal Reserve will go too far under the untested leadership of a new chairman, Ben Bernanke, who is allied with a new Treasury Secretary, Henry Paulson, with a reputation as an enemy of fiscal deficits. In their efforts to de-stimulate the economy by making money scarcer and more expensive, the bankers of the Federal Reserve could wind up making money too scarce and too expensive. That would slow growth just when the stock market needs expectations of high future growth to support stock prices against a backdrop of rising interest rates.

Which is exactly the same kind of growth slowdown that could happen if central banks in Japan, Europe, India and China make a mistake. I can't remember a time when all the world's central banks faced the same dilemma. The coincident timing certainly explains why all the world's financial markets are moving together in their worry right now.