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Friday December 16, 2005 - 11:39:46 GMT
Black Swan Capital -

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Rosy or not?


“A second general feature exemplified the October 1929 event is that a financial collapse has never happened when things look bad. On the contrary, macroeconomic flows look good before crashes. Before collapse, economists [not all] say the economy is in the best of all worlds. Everything looks rosy, stock markets go up and up, and macroeconomic flows (output, employment, etc.) appear to be improving further and further. This explains why a crash catches most people, especially economists, totally by surprise. The good times are invariably extrapolated linearly into the future. Is it not perceived as senseless by most people in a time of general euphoria to talk about crash and depression?”

Didier Sornette, Why Stock Markets Crash

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Will rising demand in Europe and Asia take up the slack for falling consumer demand in the US—assuming we ever see falling consumer demand in the US? Some economists see just that rosy scenario playing out. Others suggest if the US Administration gets one of its Christmas wishes—a Chinese yuan revaluation—Miss Rosy scenario will likely be a no show.

Morgan’s Andy Xie on China’s problems with a higher yuan [our emphasis]:

“For how much longer can China’s foreign exchange reserves sustain their rapid growth in the face of stagnation elsewhere? We suspect they may continue to grow in 2006, but at a reduced pace. In our view, the inflows are based on the perception that China’s currency may appreciate substantially, offsetting the average negative carry of 300 bps [interest rate differential]. However, we believe that China cannot afford to appreciate its currency significantly for two reasons.

“First, a significant appreciation would likely trigger capital outflows. A soft landing for the Chinese economy depends on low interest rates, which in turn require money not to leave China. If China’s currency appreciates substantially, we would expect profit-taking to result in capital outflows. Although China has capital control, capital flows in and out of the country have been very large. Also, the foreign companies that control most of China’s exports can easily over- or under-invoice to ship money in and out of the country.

“Second, overcapacity and margin pressure could turn a significant appreciation into a deflationary spiral. China has over-invested substantially in steel, auto, electronics, cement, chemicals, and many other industries. The excess capacity sometimes exceeds 100% of current sales. China needs to export to digest its excess capacity. A significant appreciation would make it much more difficult for the export strategy to succeed.

There is a big bet, it would seem, being placed on China’s burgeoning consumer market. And there is a lot of debt in the biggest one:

Northern Trust’s Paul Kasriel on “Households – Another Quarter Older And Deeper In Debt” [our emphasis]:

“Here’s the good news. In the third quarter, the market value of households’ assets increased by 2.7%. Here’s the bad news, the value of households’ liabilities increased by 3.0%. So, the leverage of households moved up to 18.24% in the third quarter from 18.19% in the second quarter (see Chart 1). The third quarter household leverage ratio is the highest since the record high of 18.32% set in the first quarter of 2003.

“A lot of the increased household indebtedness resulted from home ‘owners?’ tapping the equity in their houses. At an annual rate, households withdrew from their personal ‘home ATMs’ a net $452.3 billion. This, of course, was the principal reason households were able to consume and pay principal and interest on non- mortgage debt by an annualized record amount of a $132.9 billion in excess of what they earned after taxes.”

And of course, we have good news on industrial production and a rising stock market also juicing Mr. Consumer – why worry. This next set of graphs and comments was sent by a “very” seasoned investment pro and reader of Currency Currents (he received it from a friend of his):

“Industrial production has just been reported for November and despite the bullish spin by CNBC talking heads, its year-over-year, seasonally-adjusting growth rate is: (a) below the recent business cycle peak just before the Gulf Coast hurricanes about which we’ve previously reported; (b) less than half the growth rate of nominal GDP; and (c) it continues in its 18-month downtrend channel.
“The chart below shows this bearish pattern (blue arrows) is similar to the one that preceded the first 50% downleg in the Supercycle Bear Market that started at the March 2000 all-time stock market top in the S&P 500.
“Again, we expect the current downtrend in industrial production growth is a bearish precursor, but this time our eight-factor group quantitative forecasting model suggests it is a leading indicator for the coming second and most devastating bear market downleg in the BAAC Supercycle Bear Market, as illustrated by the red dotted arrow.”

“The good times are invariably extrapolated linearly into the future,” says Sorenette. Well, not today Rosy.

Jack Crooks
Black Swan Capital


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