3.0 Poseidon Perspective March 2010

8/9/2019 3.0 Poseidon Perspective March 2010

1/18

THE

POSEIDON

PERSPECTIVE

soundnavigationthroughperilouscrosscurrents

30March2010

DearInvestor,

Thereflationofpricesinmostequity

marketscontinuedduringFebruary2010.

Whilethere

are

several

expedient

reasons

forthisincreasedrisktaking,webelieve

thateconomicfundamentalsdonotjustify

currentprices. Wecontendthatallmajor

equitymarketsarenowoverboughtand

presentanunattractiveinvestmentoption

atthistime. Theexpansioninvaluations

maycontinueforanextendedperiodifthe

FederalReservesFOMCrefusestoraise

interestrates. Yet,weseeincreasingriskto

equityportfolios. Bondsdonotoffera

reasonablealternativesincetheFOMCwill

eventuallyhavetobeginraisingshortterm

rates. Thereturnsofferedforholdingcash

andshorttermTreasuriesarethepenalty

extractedfromprudentsaversandrisk

adverseinvestorsascentralbanksaround

theglobesupportbankbalancesheet

restructuringandencouragerisktaking.

Preciousmetals

are

still

cheap

but

they

are

subjecttoadownsideinanymajorasset

selloff. Withoutaccesstowellmanaged

hedgefundsmostinvestorsmustcontinue

tosufferthecostsofapoorlyregulated

bankingsystem. Thissituationmay

continuethroughout2010oruntilbond

marketsdemandanendtofreecredit.

TABLEAFeb10 1Year 10Years*

DJIndus 2.56% 46.2% 0.28%

S&P500 2.85% 50.3% (1.98)%

Nasdaq 4.23% 62.4% (6.91)%

DJTran 6.12% 65.4% 5.76%

S&P600 4.22% 62.5% 4.75%

MSCIEAFE (0.88)% 50.1% (1.20)%

MSCIEM 0.25% 87.5% 6.52%

WTIC 9.29% 78.0% 10.2%

*10year

values

are

the

compound

annual

growth

rate

Alookatthe10YearreturnsinTableA

presentsastrangelydysfunctionalviewof

equityreturns. Largecapdeveloped

countryequities(DJI,S&P500,MSCI

EAFE)showlittleornoappreciationover

10years. Americanhightechnology

(NASDAQ)hasseriouslylostmoney

mimicking

the

bubble

and

loss

of

Japanese

equitiessince1990. TheAmerican

transportationindustry,smallcap

companies,andemergingmarketequities

(DJT,S&P600,MSCIEM)showsolidbut

notspectaculargainsoverthesameperiod.

Oilextendsaspectacularrisedespite


2/18

THEPOSEIDONPERSPECTIVE 30March2010

developedcountriesbattlingtheGreat

Recession. Volatilityreignsasliquidity

sloshesthruglobalmarkets;historical

correlationsdonothold;weare

confounded.

Wemakeafewmoreobservations.

TableAexoneratesJimRogerswhohas

promotedcommoditiesinvestingfor

almostadecade. Whilenotall

commoditieshavedoneaswellascrude

oil,measuredherebythecontinuous

contractforWestTexasIntermediate

Crude(WTIC),otherssuchascopper,iron

ore,and

nickel

have

done

much

better.

The10yearreturnoncopperfrom81.1in

2000to340.3in2010equatetoaCAGRof

15.4%,morethantwicetheannualreturn

fromEmergingMarketequitiesYet,most

marketshaveexhibitedacrash,boom,

crash,recoverycycleoverthepast10

years. ThereturnsontheDJIndustrials,

S&P500,andtheNasdaqCompositeover

the

past

year

rescued

these

indexes

from

terriblelongtermlosses. TheDJIwasin

steadydeclinefrom20002003,advanced

thruaboomduring20042007,crashed

again,andhasnowregained75%ofits

boomprice. TheS&P500lossfrom

20002003wasadeclineof47%whichwas

reversedduring20042007toanotherhigh,

thenpricescollapsedagainin2009andhas

resurrectedto75%ofthathighduring

20082010

surge.

We

examine

NASDAQ

returnsmorecloselybelow;however,the

pointistoquestionwhethermarket

volatilityisfullycompensatedbypotential

futurereturns. Wearguethatitisnot.

Thus,thepast10yearsrevealthegreatrisk

inthebuyandholdstrategy. Ifthe

investorisforcedtosellataninopportune

time,thehaircutcanbesevere. The

returnsinTableAcertainlyendorsethe

strategytobuywhenassetsarecheap.

Oneyearagowhenfeardominatedthe

marketseverythinglookedcheaprelative

totodaysprices. Yet,wearequickly

returningtothecreditbubblehighsof

2007.

SOUNDINGS

Page 2

AlongwiththeresurgentgainsintheS&P

500therehasbeenrecentcomplacencyin

WallStreetsnotoriousfeargauge,the

VIX.We

look

at

this

index

with

an

overlay

oftheS&P500inChart1. TheVIX,left

handscale(LHS),exhibitsafewblipslast

autumnandaJanuaryfright;otherwise,it

hasbeenonasteadyslidesinceNovember

2009. Howthencanthisindicatorbe

utilizedasaforecastingtoolforthe

prudentinvestor? Notmuch,asnotedin

theMarch20FinancialTimes. TheFT

reported

that

Birinyi

Associates

published

astudywhichconcludedthatitisa

measureofcurrentvolatilitywithlittleor

nopredictiveorindicativevalueregarding

thecourseofthemarket. TheVIX

appearstobealegitimatecoincident

indicatorreflectingthegeneralreactive

panicofmoneymanagers. Wemustagree

withBirinyiandwillspeculatethat,

perhaps,theinverseistrue. TheVIXisa

buysignal

after

ashort

lag

of

time.

Sounds

counterintuitive,yetthisappears

conceivable. ShouldonebeusingtheVIX

asacontrarianindicator? Birinyi

Associatesconcursthatonoccasionsthe

VIXmightbeusefulinthatitappearsthat


3/18


Page 3

highvolatilitymightactuallybea

contrarianindicator. Academicsand

moneymangershavelongequated

volatilitywithrisk. Ifthecurrentreturnon

equitiesisbaseduponpreviousvolatility

(risk)andweareenteringanewperiodof

lowvolatility(risk)wherereturnswillbe

muchlower,whatisthepropermeasure

forcompensationoffuturerisk? Iftherisk

premiumisadequate,thenperhapswe

havereachedthesummitinequityprices

andfuturereturnswillbemuchlower. In

considerationofminimalordeclining

futurereturns,weseeacontinuationof

marketcomplacency.

CHART1 GROWINGCOMPLACENCY

Source:PSI;StockCharts

WhiletheVIXisatbestacoincident

indicatorofequitymarketdirectionthere

areothersocalledleadingindicators.

The

best

known

and

most

publicized

are

theeconomicindicatorspublished

monthlybyTheConferenceBoard

(www.conferenceboard.org). These

includetheConsumerConfidenceIndex,

LeadingEconomicIndex,Coincident

EconomicIndex,andLaggingEconomic

Index. Theseareallcloselyfollowed,

comprehensivestatisticalmeasures. The

resultsaregeneratedbyexogenous

statistical

algorithms.

However,

many

marketstrategistspreferactualmarket

prices,suchastheVIX,torevealtrends

andmomentum. Wenotetwoindexesin

Chart2,theDowJonesTransportAverage

(DJTorTRAN)andtheBalticDryIndex

(BDI). Theseindicatorsprovidesome
http://www.conference-board.org/http://www.conference-board.org/http://www.conference-board.org/http://www.conference-board.org/


4/18


revelatorymarketinformationabout

economicactivity. However,themost

importantvectorsinequitymarketmoves

arevelocityandduration;thesetwo

transportindexesarenotsolid

prognosticators.

CHART

2

LEADING

INDICATORS?


Page 4

Yetthereisoneindicatorwhichhas

tremendousimpactonequitymarket

pricingduringbothupsideanddownside

moves;itisshortterminterestrates. There

areabundantstudieswhichdocumentthe

correlationbetweeninterestratesand

futureequityprices. Thesimplest

explanationforthevalidationofthis

relationship

is

the

principle

of

efficient

substitutioninproductstoaccommodate

therisk/rewardtradeoffdemandedby

investors. Asinterestratesrisemoneywill

moveoutofequitiesandintobonds.

Anotherimpactoffluctuatinginterestrates

isthecosttocompanieswhichcarry

substantialdebtloadonthebalancesheet.

However,asfinancialmarketsare

forwardlookingmechanismscurrentrates

donotmatterasmuchexpectationsfor

futurerates. Inthecasewhereinterest

ratesareextremelylow,suchas20034or

200910,eventheexpectationofrising

rateswillnotadverselyimpactequity

prices

in

the

early

stage

of

rate

increases.

Therefore,asisclearlyindicatedinChart3,

theextremelylowshorttermrates

mandatedbytheFedhaveprovidedthe

thrustforexorbitantequitygains.

However,thisisatacosttosavers. With

anyinflationinthesystemrealinterest


5/18


ratesarenegative. Atsomepointthis

maychangesuddenlyandunexpectedly.

Themarketimpactwillbesevere.

AftertheirMarch2010meetingtheFOMC

onceagainpledgedtokeepinterestrates

lowforanextendedperiodandthe

impactwasasurgingequitymarketfor2

days. Marchsawnewhighsforboththe

DJIandDJT. Thisisastrongtechnical

indicatorthatwehaveenterednewphase

ofabullmarketinequities. Muchofthe

mediaisbullishontheeconomy.

CHART3 NOWHERETOGOBUTUP

Source:StLouisFed

Yet,aswecandeterminefromChart3we

areinuncharteredwaterswithregardto

interestratepolicy. Ratessince1960have

never

been

so

low,

for

so

long.

How

much

longertheFedsZeroInterestRatePolicy

(ZIRP)willdriveequitymarketshigherwe

donotknow. However,weknowthat

shorttermratesdrivenbytheFederal

FundsRatecannotgolower. Therefore,

wewatchlongtermrates,the30Year

Treasury,whichtheFedcannotcontrol.

Wewatchthe10YearTreasurywhichis

thebasisforsomanyderivativeproducts

including

residential

mortgage

rates.

We

watchemploymentandhousingstatistics

asbothfactorshavestrongimpactonthe

consumerdriveneconomy. Wewatchand

wewait.

Page 5
http://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FFhttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FF


6/18


Alargerpictureofcurrentinterestrate

conditionsandequitypricesispresented

inChart4. Asanindicativeratewechose

the3MonthTreasurywhichyieldsabout3

basispointsabovethe30Daynote. The

chartclearlyshowsthelowestratesinover

10yearsandreflectstheZIRPand025

basispointsrangefortheFedFundsRate.

CHART4 POWERFULMEDICINE

Source:PSI;

StockCharts

Page 6

InDecember1996thenChairmanofthe

FedGreenspanutteredhisinfamous

phraseirrationalexuberanceinreference

totheequitymarkets. Inspiteofthis

concerntheFedfloodedthemarketwith

liquidityinmid1998inresponseto

ridiculouslyexaggeratedconcernsabout

the

potential

for

computing

glitches

in

the

Y2Ktransition. Finally,theFedbeganto

increaseratesfromJune1999thrulate2000

whiletheNASDAQrepresentedinChart4

asCOMPQhadrocketedfrombelow

2000toabove5000. Whenthebubble

burstin200001theNasdaqcollapsedfrom

itshighcloseof5,048onMarch10,2000to

1,114onOctober9,2002adecreaseof

(77.9)%. Thecrashrecoveryto1,911in

2003andstabilityin2004at1,920meanta

gainof72.3%. Theclimbinprices

continuedin2005,up8.85%,in2006up

10.6%andapeakinOctober2007at2,859,

up

156%

from

the

bottom.

In

March

2009

theindexcrashedagainto1,268. Once

again,abouncefromthebottomandlower

interestrateshasresultedinagainto

2,395,up88.9%. Interestrateswill

somedaymovehigher;maybethenext

NASDAQcrashwillnotbeasbad.


7/18


Theperiodoflowinterestratesfrom2004

thru2008didnotreflatetheentire

NASDAQbubbleandhereinliesa

valuablelesson. Onceburnedreallywell,

investorsdidnotreturntothesame

fantasy. However,newmoneyandold

investorsfoundanotherplayground,real

estate. Themarketcamewithveryloose

lendingpracticessimilartostockmargin

requirementsinthe1990s. Massivecredit

availabilityandlowratesreleasedthe

explosionofmortgagedebtboth

residentialandcommercialwhichbrought

thefinancialsystemintheUStoitsknees

inOctober

2008.

Wenowfacethenextstageinfinancialand

monetaryevolutionand,whilethepastis

notprologue,theeconomyhasbeen

wallowingintheZIRPenvironmentfor

overayear. Theequitybubblehasbeen

reflatedandcommoditiesarewellontheir

waytoapotentiallyhugebubble. The

FOMC

will

meet

again

April

27

28,

2010.

Atthistimetherewillhavetobea

decision. Thecurrenttrailfollowsa

dangerousprecipice.

WEATHERWATCH

Wehavereachedacriticalperiodwhere

thefocusonUSeconomiceventsisviewed

throughtheprismofChina. TheChinese

economyisviewedasaproblem,the

potentialsolution,

or

abothersome

conundrum. Theextremitiesofopinion

haveattractedawealthofpoliticaldiatribe

andmediaattention. Investorsentiments

andselfrighteousprognosisareasvaried

asthepersonalities. Wewillnot

regurgitateBloombergheadlinesormedia

speculation. However,giventhepotential

impactontheglobaleconomyandglobal

securitiesmarketswearecompelledto

addresshoweconomicdevelopmentsin

Chinamayimpactourinvestmentthesis

andexpectations. Wefaceanenvironment

wheretheEuroisunderattack,theUSis

becomingseriouslyoverburdenedwith

debt,someresourcebasedeconomiesare

raisinginterestratestoprecludebooming

assetprices,andBrazilhasinstituted,with

Russiaconsidering,acapitalinflowtax.

Chinastilldemandsthegreatestattention.

Theconsensus

among

Wall

Streets

bullish

proponentscontendsthatChinahas

becomethegrowthenginefortheworld

economy. Wehaveconsideredthewealth

ofreporting,analyzing,andspeculatingon

theChinaeconomywithahealthydoseof

skepticism. Therehasbeensomuch

noiseinthemediathatwewererelieved

toseeEdwardChancellorsWhitePaper,

Chinas

Red

Flags

March

2010,

available

atthewebsitewww.gmo.com. Wewill

reviewindetailthisworkbyMr.

Chancellor,authorofDevilsTakethe

Hindmost:AHistoryofFinancial

Speculation,capitalmarketresearcher,

andmemberoftheassetallocationteamat

GMO.

Page 7

Mr.Chancellorutilizeshisresearchand

publishedworks

on

speculative

manias

to

createtheframeworkonwhichhebuildsa

crediblecritiqueofthecurrenteconomic

exuberanceinChina. Heregardshis

previousresearchashallmarksfor

leadingindicatorsoffinancialdistress.

Wehavecollapsedthetwosectionsofhis
http://www.gmo.com/http://www.gmo.com/


8/18


paper,thefirstwhichidentifiesthe

indicatoranditsrationaleandthesecond

sectionwhichmakestheappropriateand

currentrelevancetoChina. Theten

hallmarksare:

1. ACompellingStory;theChinaDream

Thefirstindicatoristheincrediblemagnet

ofChinatodrawuponoutsiders

overwhelmingdesire(greed)tomake

money. Chinaspopulationexceeds1.3

billionpeopleandtheexpectationisthat

overthenextdecadethat300millionof

thesepeoplewillemigrate/transformfrom

indigenous,subsistence

farmers

to

city

dwellingconsumers. Meanwhile,China

hassurpassedGermanyastheworlds

largestexporter. Chinaisexpectedin2010

tosurpassJapantobecometheworlds

secondlargesteconomy. Chinaisthe

largestconsumerofcommoditiesandis

thelargestmarketforautomobiles. Thus,

theexpectationisthatChinasGDPwill

rise

in

excess

of

8%

per

annum

well

into

thefuture. Chancellorpointsoutthatfew

analystsquestionthepossibilityofan

interruptiontotheseyearsofextraordinary

growth. Theotherunquestioned

assumptionisthatthecontinuedexodus

fromthefarmtothecitywillproduce

middleclassconsumers. Healsoastutely

notesthatChinaspopulationwillbeginto

declinein2015andthatthenumberof

personsjoining

the

workforce

will

fall

off

quiterapidly. Wewouldalsonotethat

fewanalystshaveyettoseriouslystudy

thedemographicimplicationsofChinas

onechildpolicy. Ayoungadult

population,predominantlymale,may

havesomeinterestingsociological

implications.

2. BlindFaithintheCompetenceof

Authorities;TheCommunistPartyof

China

Thestatecontrolledgrowthoverthepast

twodecadeshasmaskedamultitudeof

sins. Unlikethegangstercapitalismwhich

resultedfromthebreakupoftheformer

SovietUnion,theRedCapitalismof

Chinaishighlyrespectedforitsavoidance

oftheAsianFinancialCrisisof1997and

thecurrentglobalcreditcrisis. Oneof

themajor

wonders

is

that

so

many

ardent

capitalisthavebecomeferventadmirers

ofaneconomymanagedbycommunism.

However,pastgrowthhasbeenmanaged

bymeansofcapitalinvestmentandexport

growth. Thiscannotcontinueespeciallyin

thefaceofthegreatrecessioninthe

West. Amovetomoreconsumptionbased

growthbegsthequestionofeffective

allocation

of

capital

in

a

state

directed

economy. ChancellorstatesthatInChina,

GDPgrowthisnolongertheoutcomeof

aneconomicprocess;ithasbecomethe

object. Thereisevidencetosupport

contentionsthatlocalgovernment

decisionsoninfrastructureorrealestate

developmentsaredrivenbythenecessity

ofmeetingtheirgrowthtargets. This

misallocationisfurtherskewedby

favoritismshown

to

state

owned

enterprises(SOEs)whichreceive

preferentialtreatmentandcreatesa

forcingoutofsmallerentrepreneurial

enterprisesfromaccesstocapitalandlocal

governmentsupport.

Page 8


9/18


3. GeneralIncreaseinInvestment;The

ChinaInvestmentBoom

During2009fixedassetinvestment(FAI)

inChinaclimbed30%resultinginits90%

shareofeconomicgrowth. Astounding

butnotsurprisingsinceinfrastructure

accountedfortwothirdsof2009stimulus

spending. Manyprojectsundertakenare

institutedtomeetgovernmentGDP

growthtargets. Theseincludeairports,

highways,bridges,andhighspeed

railways. ChancellormentionstheYou

TubeclipofnewOrdos,aghosttown

whichwasbuilttoaccommodateone

millionresidents

near

to

the

old

Ordos

whichisinInnerMongolia. Alsoavailable

areclipswhichexposetheworldslargest

retailmallwhichishardlyoccupied,an

eeriesight.ThenewtownofChenggongin

SouthChinasYunnanprovincewasbuilt

toalleviateKunmingscongestion. The

mockEnglishThamesTownwasbuiltas

abedroomcommunityforShanghai.

Similar

to

the

overcapacity

of

telecom

assetsdevelopedintheUSduringtheTMT

boomofthelate1990s,thejustificationis

thatwithprojectedgrowthrates,the

capacitywilleventuallybecome

productive. AsinthecaseUSTMT

bubblethisoutcomeishighlyunlikelyin

themidterm.

Theproblemofoverinvestmentalso

plaguesthe

manufacturing

sector.

Capacityunderutilizationhasbeen

identifiedinshipbuilding,steel,flatglass,

iron,cement,polycrystallinesilicon,and

windpower. Investmentatthislevelis

quicklysubjecttodiminishingreturns.

However,itisjustifiedbyaggressive

growthexpectations.Thistypeof

aggressiveoverdevelopmentwasone

majorcauseoftheAsianfinancialcrisisof

1997severelyimpactingeconomicgrowth

inKorea,Thailand,Indonesia,and

Malaysia.

4. Corruption

ChancellorremindsusthatAllgreat

speculativemaniashavebeen

accompaniedbyrisinglevelsoffraud.

ExamplesintheUSincludeEnronand

WorldComduringtheTMTbubble;Bernie

MadoffandAllenStanfordduringthe

recentcredit

bubble.

However,

in

China

majoreconomicdegradationresultsfrom

unreasonableandpunitivelandseizures,

laxbuildingstandardsandshoddy

construction,poisonouspollution,andlack

ofenforcementofexistingregulations.

Endemiccorruptionwilllowergrowthand

increasesystemicrisk. Thislevelof

corruptioncanbeexpectedinanemerging

market

economy

but

is

not

acceptable

in

theworldssecondlargesteconomy. The

CarnegieEndowmentbelievesthatthe

indirectcostsofcorruptionareincalculable

andwilleventuallyhaveaserious

impairmentongrowth. Chinaiscurrently

rankednumber79ontheTransparency

InternationalCorruptionPerceptions

Index.

5.Easy

Money

Page 9

ChancellorreferstoeconomistFriedrich

Hayekwhoclaimedthatassetprice

inflationfollowedfromexcessivelylow

interestrates. Monetaryandcredit

expansiongenerateeasymoneywhich

feedsthroughtoinflation,eitherinthe


10/18


generalpricelevelorinassetprices.

Eitherresultisamisallocationofcapital.

Theappropriatelevelofrealinterestrates

isaburdensomeissue,asmuchanartasa

science. However,aruleofthumb

suggeststhatratesshouldtrackeconomic

growthoverthemediumterm. IntheUS

theprimeratehasaveragedaround1

percentagepointmorethanUSnominal

growthoverthepastfortyyears. Yet,in

Chinatheprimeratehasaveraged

around9percentagepointslessthan

GDP. In 2009therewasa$1.4trillion

issuanceofnewloans. Thistwinpolicyof

lowinterest

rates

and

exorbitant

money

growthhasgeneratedhighinflationwith

boomsandbustsoverthepasttwenty

years. SeeChart5whichincludesthe

ShanghaiStockExchangeComposite

(SSEC)belowforanexampleintheequity

market. LowinterestratesinChinalikein

theUSpunishsaversandinvestorswho

findthemselvessqueezedbetweenfearof

inflation

and

the

desire

for

higher

returns.

6. FixedCurrencyRegimes;Exchange

Rate&CapitalInflows

Thefixedrateofexchangebetweenthe

Chineserenminbi(RMB)andUS$has

producedmassivecapitalflowsbywayof

foreigndirectinvestmentevenwith

limitedcapitalcontrols. Thismassive

investmentalsocontributestoabnormally

lowinterest

rates.

The

extremely

large

foreigncurrencyreservesheldbyChina

areareflectionofanuntenableimbalance

inglobaltrade. Thesereservesarenota

stalwartdefenseagainstassetboomsand

busts. Theothersideofthisunstable

equationisthevastexternaldebtsrun

upbytheUS. Meanwhile,Chinahas

enabledotherAsiancountriestoalsobuild

largeforeigncurrencyreserveswhichmay

provideafalsesenseofeconomicsecurity

duringtimesofglobalstress. Thereisan

apprehensiveshadowplayinthiscurrent

entanglement. Chinareflectsalarger,

moreintensereplayofJapaneseexport

policyduringthe1980s. Meanwhile,the

UnitedStatesafteraperiodofgross

overconsumptionisfollowingtheJapanese

pathofcreditbubbleresolutionwhich

includesZIRP,quantitativeeasing,and

zombiebanks.

7. RampantCreditGrowth;theCurrent

CreditBoom

During2009banksinChinaincreased

lendingbynearlyRMB10trillion,asum

equivalentto29%ofGDP. Thishuge

impetustotheeconomywentlargelyto

infrastructureprojects,property

development,andstateownedenterprises.

One

can

look

to

the

current

US

malaise

to

seetheresultsofmassive,shorttermcredit

growth. AswithUSsubprimelending

theremustalsobeaconcernaboutthe

deteriorationofunderwritingstandards

whenacreditsurgeofthismagnitude

occurs. EconomistsattheBankfor

InternationalSettlementshaveshownthat

sharpdeviationsofcreditgrowthfrom

pasttrendshavepredictedfinancialcrises

withan

80%

success

rate.

8. MoralHazard

Page 10

Chinesebankswhichareamongthe

worldslargestinassetsarestateowned.

Theyareviewedasakeyinstrumentof

Beijingseconomicpolicyand,thus,


11/18


deemedtobigtofail. However,the

problemofmoralhazardknowsno

geographicaldemarcationsandoneneed

tolookonlytoJapaninthe1980sandthe

UnitedStatesinthemid2000stoseethe

potentialpitfallofcompromisedlending.

TheAsianfinancialcrisisof1997involved

poorlendingdecisionsatgovernment

influencedbanks. Inthelate1990s

ChinesebankswereestimatedbyStandard

&Poorstohavenonperformingloans

around50%oftotaloutstandingloans. In

thisinstancethebailoutand

recapitalizationappearedrelatively

painless.During

the

most

recent

ramp

upinlendingHongKongbanksoperating

inthemainlandwerecuttingbackonnew

loans.

9. PrecariousFinancialStructures;Risky

LendingPractices

Unfortunately,theUSEuroJapmodelof

lendingwhichgreatlyreducedstandards

during

the

boom

times

may

have

rubbed

offinChina. Manyoftheinfrastructure

projects,tollroads,bridges,airports,and

railroads,sponsoredbylocalgovernment

authoritiesappeartohavelittleorno

currentcashflow. Onceagain,the

expectationisthattheeconomywillgrow

intothisexcesscapacitythusgenerating

therevenuetofundtheinvestment. As

withmoralhazard,riskylendingpractices

andworking

around

capital

requirements,

sometimes,becomestandardbanking

practicesduringtheboomtimes. While

WallStreetanalystsaregiventoclaiming

thatChinascreditsystemisrobust

becauseloansarenotsecuritized,other

offbalancesheettacticsandthereluctance

toprovidefulltransparencyinproviding

informationonproblematicloansmean

thattrueevaluationofabankscapital

strengthisquestionable. Fewseemtocareaboutthepracticeofconcealingnonperformingloanssinceitsgenerallyassumedthatsolongas theeconomycontinuesgrowingquickly,badcreditswillturngoodovertime(ECsitalics).

10. RapidlyRisingPropertyPrices;The

Bubble

Onceagain,Chart5indicatestherapid

recoveryoftheSSECin1H09which

coincideswith

Chinas

massive

fiscal

and

monetarystimulus. Highstockturnover,

arisingnumberofnewshareissues,strong

earlytradinggains,andtheestablishment

ofnewstockexchangesareallclassicsign

ofspeculativeeuphoria. Onceagain,

marketgains,highvaluations,theSSEC

tradingat38timeshistoricearningsare

justifiedbythecountrystremendous

growth

prospects.

Page 11

Chancellorcontinuesthattherealred

flagsareflyingoverthefreneticproperty

market. Residentialrealestateispowered

bylowreturnsoncash,thevolatilityof

stocks,andawidespreadbeliefthat

propertypricescanonlygoup. Lowered

lendingrates,increasedloantovaluefor

mortgages,discountstosecondhome

buyers,residency

permits

to

buyers,

and

taxbenefits,workedtheirmagicwith

stunningresults. Theincreaseinsalesof

residentialpropertiesfrom2008climbed

87%toRMB3.8trillionin2009. The

averagehousepricerose8%. New

constructionhasfollowedrisingby16%


12/18


thruNovember2009andtheexpectationto

riseanother20%in2010. Unfortunately,

migrantworkerscannotaffordnew

housingpricesinthecities,buthome

ownershipratioshaveclimbedto70%.

Muchofthetakeupisnowinthehandsof

investorsbecause,onanationalbasis,

homepriceshaveclimbedtoaround8

timesincome. InBeijing,thehouseprice

toincomeratiohasclimbedabove15times

(itsaverage20002008was10times). By

comparison,Tokyocondopricespeakedin

1990at9timesaveragehousehold

incomes. Onceagainanalystsarenot

concerned.

Thecommercialpropertymarketreflectsa

similarhyperexpansion. Commercial

realestateinvestmentgrewby21%last

year. Thetotalamountoffloorspace

underconstructioninChinaisequivalent

insizetoRhodeIsland. Banklendingof

$202billioninJanuary2010willassist

continued

growth.

Gross

area

under

constructioninChinaroseto3.2billion

squaremetersin2009. Thisamount

equatestoapproximately35.2billion

squarefeetortheequivalentofa27square

footcubicleforeverypersoninChina.Jim

Chanos,seebelow,usesthisanalogy.

AccordingtoBloombergDowntown

Manhattanhas87millionsquarefeetof

officespace;thus,Chinahasunder

constructionover

400

Downtown

Manhattans. Thenefariousdevelopment

loopwhichincorporatesmoneyflowsfrom

stateownedbanks,precariouscredit

expansion,corruption,misallocation,and

blindfaithiscompletedthroughlocal

governmentswhichowntitletoallland

inthePeoplesRepublicandhavebeena

majorbeneficiaryoftherealestate

boom. Stateownedenterpriseshavebeen

calledupontosupportcontinuing

development. Thiscircusisunderwayata

timewhenvacancyratesarerising. Inthe

PudongdistrictofShanghaibuilding

continuesdespitevacancyratesof50%.

WefindthatChancellormakesa

compellingargument. Inhisbookhehas

notedcomparative,historical

developments. Thebiggestquestionsare

whenthiswillunwindandwhattheglobal

repercussionswill

be.

Chancellorisnotaloneinexpectationofa

breakdowninChinasgrowth. Harvard

economistKennethRogoffisinagreement

withtheeventualcorrectioninChinas

extraordinaryrecordindevelopment.

DuringaninterviewinTokyoinFebruary,

BloombergquotedhimtosayYourenot

going

to

go

a

decade

without

a

bump

in

theroad. Rogoffbelievesthateconomic

growthcouldplungeto2%afterthe

collapseofadebtfueledbubble. He

believesthatrealestateisaprimecatalyst

forthecollapseaspricesinBeijingand

Shanghaihavetakenadeparturefrom

reality. However,Rogoffbelievesthatthe

correctionwillbeafairlyshortpainful

periodinthecontinuationofChinas

strongeconomic

growth.

Page 12

JamesChanos,PresidentofKynikos

Associates,hedgefundmanager,and

respectedshortseller,madeafortuneand

areputationshortingEnronadecadeago.

HelecturedatStHildasCollege,Oxford


13/18


UniversityonJanuary28,2010,available

onYouTube. Thetitleofhispresentation

wasTheChinaSyndrome,WarningSigns

AheadfortheGlobalEconomy. Mr.

Chanoswasnotmakingacallfor

imminentdoominChina. However,heis

soundinganalerttothosewhobelievethat

continuingdevelopmentinChinawillbe

theengineforglobalgrowth. Infact,a

slowdowninChinaforanynumberof

reasonsbutmostimportantly,excesscredit

collapse,wouldputasharpdentinworld

GDPgrowth. ExcessiveFAIhasresulted

inovercapacityinmanysectorsofthe

economy.This

excess

capacity

is

creating

strongdeflationarypressures. Therecord

levelsofFAIarenotsustainableandare

creatingmassivemaintenancecostsforthe

future. Theresulthasbeenalargeuptick

incommoditypricesespeciallyindustrial

metalsandmaterials. Chanoshas

admitteditmaytake45yearsforhis

scenariotoplayout

TheChanoshypothesishasmuchcredence

ifwelooktothehistoryoftrade

dominationandworldcurrencyreservesin

the20thcentury. Hepointstothetwo

timeswhenonenationsodominated

worldtradethatitscurrencyorgold

reservesrenderedittheroleofeconomic

superpower. ThefirstwastheUnited

StatesfrompostWorldWarIeraintothe

1920s.During

this

period

the

US

accumulationofgoldledtostockmarket

andrealestatebubblesoflate1920s,

followedbyamajorcurrencyrevaluation,

andthesubsequenteconomiccollapseof

the1930s. Thisexperiencewasrepeated

inthe1980sinJapanwhereanexport

superpowersaccumulationofcurrency

reserveseventuallyresultedinrealestate

andstockmarketbubblesin1989,a

currencyrevaluation,andthelostdecades

fromthe1990suntilnow. Wewouldlike

toreiteratethatwhileChinaisinaunique

position,therearetwoclosehistorical

correlatives. TheChinesepolicymakers

arewellawareofthepastandespecially

theJapaneseexperience. However,the

currentexplosioninlendingandresultant

developmentofovercapacityin

manufacturing,infrastructure,andreal

estatearetheindicatorsforeventual

correction.Chinas

foreign

currency

reservescannotprotectthemfrom

themselves. Chanossuggestedthatthe

bestwaytoplaythecomingcorrectionin

Chinaisbyshortingthoseprovidersof

materialswhoaremostsusceptibletoa

majorcorrection

Page 13

InChart5wenotethebubbleexpansionin

Chinese

equities

expressed

by

the

rise

of

theSSECfromMarch2005thruOctober

2007,from1,172to6,092or420%in31

monthswhichequatestoacompoundrate

of5.46%permonth. Thedownsidewas

justasquickbutnotquiteaslowand

commoditiesfollowedthetrailinlessthan

ayear. AsduringtheJapaneseexperience

in1980sandAmericanexperiencein1996

2006theequitiesbubbleandcollapse

morphedquickly

with

the

added

stimulus

ofverylowinterestratesintospeculative

realestate. InChart5wehaveshownan

underlayoftheCommoditiesResearch

Bureau(CBR)index. Bothindexeshave

recoveredfromtheirbottomsbutremain

substantiallybelowtheirtops. Thepattern


14/18


Page 14

isanalogoustotheUSpatternwhere

investorsburnedinequitiesmoved

quicklyintorealestate. Thecaseof

commoditiesisadifferentandmore

complexassociationofsupply,demand,

exchangerates,anddifferentiationamong

industrial,agricultural,andprecious

metals. Welookabitcloserbelow.

CHART5 FOLLOWINGTHELEADER?


PROVISIONING

DuringtheSummer2009therewasagreat

dealofconcernabouttheChinese

economyasequitymarketsbeganaquick,

steepdecline. AtthetimeAsianinvestor

andeconomistMarcFabertoldCNBCthatTheChinesegovernmentisoneofthefew

governmentsintheworldthatknowsits

GDPnumbersthreeyearsinadvance. He

followedwithIdbeabitcarefulabout

China. InhisestimatetheChinese

economywasgrowingat2%andnotthe

7.8%whichthegovernmentreported.

Whatevertherealrateofgrowthhappens

tobewelookatthemarketsfor

verification. Inthiscasewelookatthe

commoditybuilding

blocks

for

rapid

development,WTICandCopper. One

couldalsolookatcementandironorewith

similarresults. InChart6weshowthe

pricesofthesebasicdevelopment

commoditiesoverthepast13years.


15/18


CHART6 BUILDINGBLOCKS


Page 15

Thepricesclearlyindicatearesponseto

marketfactorswhichbeganin2004. In

retrospectwe

can

intuit

the

factors

in

price

volatilitywhichare,supply,demand,

speculation,andexchangerates. Inbrief,

miningorotherextractiveindustriesarea

longterm,capitalintensiveundertaking

andunlikefarmingwhereoutputcanbe

rampedupquicklywiththeuseofuntilled

land,thesupplyisconstrainedinthe

shortterm. Yet,globaldemandhasbeen

growing

primarily

due

to

rapid

developmentinSouthandEastAsia.

Speculationfollowsondemand. The

massivemoneycreationwhichhas

resultedfromquantitativeeasingfirstin

Japan,thenEnglandandnowtheUShas

createdanabundanceofhotmoney

spreadacrosstheglobethruacarrytrade

accommodatedbyZIRP. Thischeap

moneypolicy

and

Chinas

abundant

cheaplaborarethemagnetforthethird

pillarofproduction,materials.

Commoditiesareanaturalhavenand

hedgeforthoseinvestorswhoharbor

inflationexpectationsandthepossibilityof

continuingvolatilityinstocksandbonds.

Finally,wemeettheexchangerate

conundrum. Themajorcommoditiesare

priced

in

US$s

as

the

US$

weakens

commoditiessuchasoil,copper,and

preciousmetalsriseinprice. Many

commoditiesprovideasolidhedgeagainst

avulnerableUS$. Anappreciationofthe

ChinesecurrencyintermsoftheUS$

wouldmakecommoditiescheaperfor


16/18


Chinaandmayacceleratedemanddriven

bypotentialstockpiling. Thecomplexityof

theseuncertaintiesisexacerbatedbythe

sizeandspeedatwhichmoneyflowsnow

travelthrutheglobalfinancialsystem. We

believethatoilandcopperareindicativeof

thecommoditieswhicharedirectlylinked

toAsianandemergingcountry

development. Anyinterruptioninthe

continuingexpansionofChinaandIndia

willgreatlyimpactprices. Theother

conundrumiswhatthesepricesaretelling

usaboutinflation. Commoditypriceshave

traditionallybeencloselylinkedwith

inflationexpectations.

CHART7 BACKTOBOOMTIME


Page 16

InChart7welookmorecloselyatthe

speculativeplayonmetalsbymeansof

investingintheduopolisticproducersof

iron

ore.

The

two

are

BHP

Billiton

Ltd.

(BHP)andRioTintoplc(RTP),hugemulti

nationalminers. Thecontinuingdemand

forironorebysteelmanufacturers

especiallyinChina,Korea,andIndiaare

reflectedinthevaluationsofthese

companies,boom,crash,reboom. The

challengeatthispointishowtointerpret

themultivariatefactorswhichdenominate

reasonablevaluationsformineralassets.

Chart

7

describes

the

pricing

which

equity

marketshaveassignedasindicativeof

currentvaluation.JimChanoshas

presentedaclearnarrativebasedupon

Chinasfuturedemandforhisvisionof

valueincontradictiontotheseprices. Who

iscorrect,timewilltell.


17/18


Thegrowingfrustrationandconfrontation

betweentheUSandChinaisasignthat

furthereconomicdisruptionmightbe

expectedbetweentheworldslargestsaver

andlargestdebtor. Whileexchangerates

maynotbethemostimportantissuethat

thetwonationsmustaddress,ithas

becomethemostmediaintensive. TheUS

creditcrisis,globaleconomicstimulus

packages,centralbanksmonetary

adjustments,andtheaccelerationofAsian

developmentareinfluenceswhichhave

notfullyrevealedtheirtruesuasionand

jostleuponthenexusofworldfinancial

markets. Thehyperactivemovesby

marketstothecontinuingbombardmentof

statisticalandspeculativeinformationover

thepast2yearsappeartohaverejuvenated

globaloptimismandrisktaking,perhaps,

excessively. Therearetimestoactand

timestocontemplate. Therefore,wesit.

WearrivedbackinNorthernVirginiaintimeforthevernalequinoxonMarch20,2010,that

briefperiod

when

day

and

night

are

nearly

equal

with

daylight

in

ascendance.

An

end

to

the

harshrainsgavewaytowarmsunnydayswithsharpchillyevenings.ThearrivalofSpringis

ahectictimefornature. Thebirds,thebees,theflowers,thetreesdisplayabeautyandan

energywhichseemsoutofcontrol. Cherrytreesexplodedinpinksandwhites. Daffodils

poppedupovernight. Theuncannycombinationofmoistureandwarmthproduces

shockingchange. Theimpactisradiantandvibrant. Thebeautyinnatureisbeyondour

control.

ThespringdisplayofpowerandchangewasprecededalmostaweekbyDaylightSaving

Time

(DST),

a

minor

but

well

publicized

change.

It

is

mans

attempt

to

adjust

more

productivelytothecycleofnature. Thisrusewhichshiftsanhourofdaylightfromtheearly

morningtothelatereveninghasneverbeenpopularwithfarmersorotherswhowork

closelyintunewiththesun. EvennowtheUKdebatesthebenefitsandparametersfor

BritishSummerTime,theequivalentofDST. LondonbusinessmenbattlewithScottish

farmersoverissuesofschedulingdaylightandcoordinatingtimezoneswithcontinental

Europe. However,theseprerogativesaremenialincomparisontotherealcommandoftime

whichwasinstitutedbytherailroadsinthe19thcentury. Itwastheeconomicpowerofthe

railroadfirstinEuropeandthenAmericatodetermineandsettimezonesandstandards.

Profitabletraintravel,passengerandfreight,demandedadherencetowellstructured

timetablesfor

the

economic

and

social

benefit

of

all.

Setting

of

standards

is

an

onerous

task;

foronceestablishedthesestandardsmaybeveryhardtochange. Wearecreaturesofhabit

andsometimesignoreourrationalselfinterestinfavorofinertialsloth. Sometimeswe

ignoreorfailtoperceivemanyoftheaggregatedconsequencesofsimpleexpediencies. The

rationaleforthegovernmentmandatingofDSTwasenergysavingsattheendofWorld

WarI.

Page 17


18/18


Almostonehundredyearslaterwecontinueapracticewhichisirrelevantinaccordanceto

itsoriginalpurposes. Someeconomistswillalwaysbeabletojustifywithvigorastandard

whichispoliticallyadvantageous. However,governmentmandatescanhavelongterm

implicationssimilartobuildingadam. Thisintrusionuponnatureisgreatbenefittothose

whoareinneedofhydroelectricpowerorthosewhosuffertheseasonalfloodingwhich

occursdownstream. Yet,thedamisaterribleburdentothoserelocatedfromthe

upstreamstoragearea. Thedemandsforstabilityandprotectionaresubjecttosurrendering

autonomy. Webarterthevagariesofnatureforthefiatofmen. Thisremainsastrueinthe

worldoffinancialmarketsasinthephysicalrealm. Oncethestandardissetordamisbuilt

thequestionwillremainwhocontrolstheflow,therateofchange. Democracyassumes

thatitreflectsthewillofthepeople. Whowillvoteforhigherinterestrates?

Sincereregards,

BrianE.Shean,CFA

PRINCIPAL

POSEIDONSTRATEGICINVESTMENTS

_________________________________________________________________________________

Page 18

Theviewsexpressedinthiscommentaryarethoseoftheauthoratthetimeofcomposition. Theassumptions,analysis,and

conclusionsaresubjecttochangeinconjunctionwithchangesinthesecuritiesmarketsordiscoveryofadditionalor

conflictinginformation. Allinformationconveyedhereinhasbeendeduced,compiledorquantifiedfromsourcesthoughtto

beconsistentlyreliable. Thisinformationalreportisproducedforgeneralcirculationandisnottobeconstruedasa

solicitationtobuyorsellsecurities,financialinstruments,orinvestmentproducts. Priortoenteringanytransactionsfor

investmentproductspleaseconsultacompetentfinancialadviserandundertakeproperduediligence. AMDG

Documents

3.0 Poseidon Perspective March 2010