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Tuesday January 12, 2010 - 15:45:38 GMT
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Complacency vs. Risk Aversion Probabilities Seemingly Rising

Key News
China raised the proportion of deposits that banks must set aside as reserves. (Bloomberg)
Carlyle Group unveiled plans to work with city authorities in Beijing to establish a renminbi fund that will enable it to make local currency investments across China.(FT)
An International Monetary Fund (IMF) stand-by deal with Turkey would help reduce the Treasury's debt rollover ratios and protect the country against future shocks, Finance Minister Mehmet Simsek told Reuters. (Reuters)
The balance of Japanese bank lending fell from a year earlier in December for the first time in four years as companies remained sceptical about the economic outlook and wary of borrowing to expand their business. (Reuters)
Heavily dependent upon hard-to-get bank loans and shut out of Europe's embryonic corporate-bond market, small and medium businesses here have been hit hard. The result: widespread insolvencies, job losses and a cloud over Europe's growth prospects in 2010. (WSJ)
The dollar edged higher on Tuesday, after an official from a Chinese sovereign wealth fund said he did not think the greenback would depreciate much further.

“As always, companies and investment banks have no trouble in meeting the new demand. Emerging market IPOs have been running at double the cash value of developed market IPOs, despite the much smaller market scale.
What’s wrong with this picture? Plenty. Academic studies have shown there is no positive correlation between GDP growth and stock market returns – if anything the correlation is slightly negative. Professor Jay Ritter of the University of Florida is the author of one such study ranging over a hundred years of data from sixteen different countries. His conclusion is clear: “Countries with high growth potential do not offer good investment opportunities unless valuations are low.”
The reason for this counter-intuitive finding is that you do not buy shares in the statistical construct known as GDP. You buy the shares of real world companies. In immature fast-growing economies, the companies that end up winning the struggle for survival may not even exist yet. That was certainly so in the case of Japan’s economic miracle. In the 1950s there were more than one hundred motorbike companies. The market leader, Tohatsu, was driven out of business by the cut-throat pricing of a flaky upstart called Honda.”
      Peter Tasker  
FX Trading – Complacency vs. Risk Aversion Probabilities Seemingly Rising
This morning, writing in the Financial Times, long-time Asian market seer and excellent analyst/writer Peter Tasker tells us most emerging markets are looking dicey, given the overvaluation.  The biggest problem flows from the biggest one—China, according to Tasker.
Early last week, emerging markets guru (well deserved we might add for his excellent work over the years) Mark Mobius sounding a similar warning, suggesting EM equities were overdone and the rush of IPOs was not good.  
This morning China decided to raise reserve requirements on its banks, hinting of bubbulicioness concerns.  Back to Mr. Tasker [our emphasis]:
“So are valuations low enough in the emerging markets to offer good investment opportunities? In less popular areas, perhaps yes. But the bigggest of them all, China, is in a bubble phase. At its 2007 peak, the Shanghai A-share index traded at over 7 times book value, far above the 5 times reached by Japan’s Nikkei Index at its peak twenty years ago.
“Having subsequently halved, Chinese stocks are no longer quite so expensive. However the adjusted  ‘Graham-and-Dodds’ price-to-earnings ratio – a time- tested indicator of value which uses an average of ten years earnings – remains at a  dizzying 50 times. Compare that with around 15 times in the US, itself by no means cheap in historical terms.
“Residential real estate [in China] appears to be even more overvalued. In bubble-era Japan, a byword for manic real estate speculation, apartment prices peaked out at 12 to 15 times average household income. In major Chinese cities, the multiple is currently 15 to 20 times. Asset market bubbles of any scale and duration usually have their equivalents in the real economy. The biggest distortion in the Chinese economy is the explosion in fixed asset investment to an eye-popping 50 per cent of GDP. By comparison, Japan in its miracle decade clocked up economic growth rates similar to China’s today by investing between 30 per cent and 35 per cent of its GDP.  
“Just as there has never been a bubble that hasn’t burst in the end, so there has never been an investment boom that hasn’t been followed by a bust. If China’s investment-to-GDP ratio were to drop to the levels of 1960s Japan – not an absurd idea, since that is also where it was in China ten years ago – the impact would be catastrophic. China itself would face slump and the mother of all banking crises. A domino reaction would hit the commodity exporters and other emerging economies. The deflationary impact of Chinese overcapacity would be felt everywhere, potentially putting the world trading system at risk. And investors would come to view the ‘Bric’ acronym much as they do ;TMT’ today.” 
The problem is, betting against a Chinese bust hasn’t been a very profitable thing to do.  Like those of us who watched the Nasdaq boom in the late ‘90’s; fading that trend proved consistently deadly even though we knew it would end badly—when it would end was the little wrinkle few figured out.  Ditto China.  But it could be a mother of a bubble burst when it does.  Rising interest rates at the margin, as I talked about recently, have been the catalyst for things like that in the past.  
What could keep the music playing longer than expected now, despite rising bond yields?  Hot money flowing into China in expectation of some type of one-off revaluation of the currency—yuan (or the even harder to pronounce and spell Remnimbi).  But we’ve seen this game before also.  We’ve seen plenty of unsuspecting investors sucked into the “exciting” Chinese yuan deposits in expectation of revaluation by questionable institutions extolling said virtues, even though it has proved to be dead money for years as the interest paid is miniscule or zip—fees paid to the institutions by investors are a bit higher, however.  No names mentioned in order to protect the guilty.   
Maybe its part and parcel to “a firm that never met a politician who couldn’t help jockey it closer to power interests,” aka the Carlyle Group’s decision to pony up closer to China with its new obviously well-connected local currency investment fund.  Here’s to hoping Carlyle’s timing is about as good as Blackstone’s venture into real estate; them having taken it off the hands of rich old Sam Zell just in time.  Sorry.  I should stop wishing bad things for seemingly questionable people.  My apologies!  It’s yet another New Year’s resolution already gone bad... 
To use JR’s title from yesterday, everything is looking hunky dory, the S&P and evaporating volatility is telling us things are indeed hunky dory.  Take a look at this picture we shared with our Members yesterday:
You notice the breakout in SPU (black line) from that wedge…just above the 50% retracement level from the pre-credit crunch high to the post-credit crunch low.  VIX (red line) is testing its old lows.  Extended?  We think so! [Chart not available in text format.]

Complacency rules!  And so far it has been very right.  But then again nothing new here; very happy campers are the prelude to very frightened campers.  It is the way the market is and the way the market has to be.  The Tao of markets! I stole that from a man who has forgotten more about currencies and markets than most will ever know, John Percival of the venerable Currency Bulletin.  Thanks John for all the wisdom you have shared for many years.  
So the currency play that might lead, or at least accompany, a pack of frightened campers out of stocks, here there and everywhere, is likely the EUR-JPY pair; or is it the AUD-JPY pair, or is it…. [Chart not available in text format.]

Stay tuned.  
Jack Crooks
Black Swan Capital LLC  


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