EMI 022814

“Sell down to the sleeping point.” - Jesse Livermore

Markets (in general) are going up so what is there to worry about? I worry that we may be getting ahead

of ourselves and it is keeping me awake. I tried counting sheep but have decided instead to count the

warning signs. There are several that we will look at now to determine if we should go with them or do

we go with the sheep and keep buying?

At the beginning of the year we looked at the meltdown in emerging markets and concluded it was

overdone and that investors would soon separate the wheat from the chaff. That is what seems to have

happened thus far. While fast money in equity markets panicked, fixed income demand for EM debt

remained encouragingly stalwart. According to Dealogic, EM governments and agencies have sold $29.8

bn worth of bonds so far this year – the highest level on record. Indonesia and Mexico both successfully

flogged US$4 bn in debt and even tiny Slovenia managed to pitch out the door a $3.5 bn note

(equivalent to $1,750 for every man, woman and child in the country). Slovenia may be unique, as the

official Slovenian Tourist Board takes pains to point out on their website: “Slovenia is the only country in

Europe that combines the Alps, the Mediterranean, the Pannonian Plain and the Karst.” I love Karst.

Equity markets in EM world have begun to recover and EPFR Global reports redemptions in such equity

funds for the week to February 19th fell to $1.5 bn; their lowest level since November. Is it time to

breathe a sigh of relief, keep calm and carry on? Valuations are compelling and the outlook is not so

bad. Left undisturbed, emerging markets have further to run.

Decoupling at the worst time

We should ask, what else could destabilize emerging markets this year? Obviously, if the US tanks that

would pull us all down as emerging markets may “decouple” on the way up they never seem to

“decouple” on the way down. As the S&P 500 finally clawed its way into positive territory for the year

this week, further encouraging the bulls (of which herd I have been but a small bullock) now is a good

time to ask: is the US market overbought and heading for a crash? There are some serious warning signs

extant which we will look at and pretty much dismiss – bar one.

1) Buffett’s rule…

Warren Buffett’s favorite measure of stock market valuation is reportedly the ratio of market

capitalization to GDP. As he says despite its limitations, “Still, it is probably the best single measure of

where valuations stand at any given moment.” Using the market capitalization of the NYSE and

NASDAQ, valuations today stand at 135% of the $16 tn US GDP. The ratio reached that level - 135% - in

2007 just before the GFC and bubbled as high as 183% of GDP in 2000 during the tech boom. At the

bottom of the GFC in March 2009 market cap to GDP was only 73%. On the surface the current level

does look alarming but further analysis indicates the ratio has actually been above 100% for all but 17

months since 1996 and has averaged 121% since Greenspan’s “irrational exuberance” speech that year.

Globalization has continued apace and now half of S&P 500 profits come from outside the US. Using the

relationship of stock market capitalization to the total sum of the country’s goods and services may be a

bit outdated if we are dealing with a global economy. To illustrate this further, let’s see what our good

friends at GS have to say. GS examined geographic revenue sources for all 500 companies in the S&P last

year based on 10-K filings and here is what they found:

The domestic US market, as of Q2 2013 accounted for just 66% of revenues for S&P 500 companies. Is it

fair to measure stock market valuation against this, admittedly large but single component and ignore

the other (growing) 44%? Don’t think so. Let’s move on.

2) CAPE Fear

Another potential red flag that concerns conservative investors (ie, those who will be around for the

next cycle) is the very high CAPE (Cyclically Adjusted PE) ratio, which currently stands at 25, while the

market PE for the S&P 500 is now just 17. Nobel Laureate economist Dr. Robert Shiller (“Bob” to his

friends) created this market valuation metric as an improvement over traditional one-year trailing or

forecast PE ratios. The CAPE ratio uses inflation-adjusted earnings over the last 10 years to smooth out

business cycles and the data stretches all the way back to 1871. CAPE fans point out the ratio is now

about 50% above its historical average. While the CAPE ratio hit a high of 43 in the spring of 2000

indicating extreme over valuation right before the tech bubble popped (cool), it totally failed to predict

our current bull market which began in 2009 (not cool).

As can be seen from the chart above (The WSJ, November 2013) with the exception of a brief but

exhilarating plunge during the GFC, the CAPE ratio has remained above its historical average level of

16.5 for almost 20 years. Selling stocks above that line of 16.5 times during that period instead of buying

them would have been a career-ending decision. A cyclically adjusted PE ratio of 25 means investors are

willing to pay this level for average future returns of just 4% per annum. If you are happy with 4%, and in

a world gone wild 4% may not be that bad, then the market is not dangerously “over-priced.” Not

enough reason to lose sleep here.

3) The People’s Currency

As I write this, some credit signals in China are beginning to flash a bright “red.” First we have slowing

growth in the general economy, which the whole world knows about. Then we have China’s subprime,

what in polite circles is called “shadow banking,” growing like a weed on crack: assets in all trusts

jumped almost 50% last year to a record 10.9 trillion Rmb. January money supply growth (M1) then

plummeted, growing only 1.2% (the lowest rate of growth since records began in 1996) and the PBoC

withdrew 658 bn Rmb from the financial system this month. Lastly, over the last few days the previously

rock-solid Renminbi (“People’s Currency”- nomenclature to make any capitalist shudder) has begun to

melt down:

Is the about-face in the currency due to a sudden unwind of the long-yuan/short dollar carry trade?

Well, that unwinding is the result, not the cause as these movements bring unwelcome sudden volatility

to what has heretofore been seen as a one way bet. Or is it a result of a nefarious strategy at the PBoC

to weaken the currency as a supportive measure to counter slowing growth and a malfunctioning credit

system? (This I highly doubt). Or is the PBoC prepping the market for its much expected widening of the

daily trading band from a dull 1% to a thrilling 2%? The Renminbi is, after all, a managed currency and

trades where Beijing wants it to trade.

While the PBoC has publicly denied being behind the recent movement (despite they are the ones who

set the daily onshore rate) it is interesting to note the weakening began right after a two-day currency

policy meeting ending on February 18th. A weaker Rmb warns off speculators and may also be an

attempt to discourage increasing “hot” capital inflows - which have been strong.

Despite such sudden and dramatic moves for a managed currency large capital outflows have not been

behind this. With almost US$4 trillion in f/x reserves (40% of GDP locked up and like a schoolboy playing

hookie they are doing nothing much) and a billion dollar a day trade surplus - any depreciation of the

Rmb is likely temporary. This is not a cause for concern.

The most important sector in the world is taking a bath

Yet the sudden move in the Rmb is likely spooking investors into a vicious feedback loop as credit

spreads are widening and credit default swaps on the big banks Bank of China (3988 HK) and ICBC (1398

HK) are up 32 bps this year to 153 bps and 165 bps respectively, according to BBG. A flight to quality is

underway as domestic institutions move into sovereign debt. Speculation in the market that ICBC and

other big banks have suspended loans to property developers is scaring investors. Some see the China

property sector, with its direct influence on demand for appliances, autos, gold faucet heads and all that

faux Louis XIV kitsch your upwardly mobile Chinese consumer loves as “the most important sector in the

world.” A government-directed slowdown here through the suspension of credit supply will certainly

help undermine confidence people have of investing in China risk assets at the moment.

4) “Everything is gold, everything is equal

Posted on the porch just chillin', me and my people” “Gold,” – Macklemore

Demanding my attention

The other warning sign beginning to flash is the rising price of gold. Spot gold is up 11% ytd and this is

only February. Ukraine, while interesting and (absent another Crimean war) doesn’t matter, emerging

market wobbles last month do not matter either. Gold is rising as the warm nurturing hand of the Fed is

being slowly removed from the market. What does that tell us?

There is a curious signal in financial markets that demands attention right now: what is going on with

gold? Spot gold price is up 10% ytd – the best start in 30 years. This chart of gold spot prices looks rather

similar to the Renminbi one above:

2013 was an annus horribilus for gold which fell 27% and is due for a bounce. But are we looking at a

dead cat here or is price action warning us of something else? Traditionally gold prices are a rectal

thermometer useful for measuring deep fear and lack of continence confidence. Gold prices rise with

stress in the system, no argument there. But before we sell everything and buy guns and canned food

again let’s examine if a rising gold price has any predictive value. The chart below compares spot gold

prices as represented by the London Gold Market Fixing Prices Index to the S&P 500.

For the last five years spot gold prices have not told us anything in regard to stock prices. In 2008 gold

and equities both cratered. From 2009 until 2011 they both soared. Gold fell 27% last year and stocks

kept rising. Gold is bouncing so far this year but ETF selling is still occurring and stocks, well, they are still

going up. The question to ask is not if gold is a good predictor of stock direction because clearly it is not

but rather who is buying gold and why?

Last year China became the world’s largest gold market, according to the World Gold Council data

released earlier this month, with consumer demand rising 32% to 1,066 tons. (India consumer demand

also grew a healthy 13% to 975 tons). Global prices fell, however, due to massive liquidation in gold ETFs

to the tune of 881 tons overwhelming demand increases elsewhere. Demand is clearly shifting from

west to east and aside from nervous Chinese consumers, some speculate the PBoC is secretly

accumulating the metal.

As we wrote a year ago, China is the world’s largest producer of gold and has not updated its official

gold reserves of 1,054 tons since April 2009. Given total mine production last year was 428 tons and

gold imports from Hong Kong alone reached a record 1,158 tons, one would not be far wrong to

conclude China owns a heck of a lot more gold than it wants us to know. Officially, the US has the largest

gold reserves: 8,133 tons – and the reality is probably less. China’s reality is probably way, way more

than what it reported five years ago and the country could already have passed the US to own the

largest gold reserves in the world.

The 32% y-y surge in Chinese consumer demand for gold last year is, I think, the most interesting point.

Chinese love gold and all own some. All. Yet, it has been the experience of this author’s many hard and

sweaty years on the ground in Asia they do not see gold as an “investment” but rather an insurance

policy or store of value. While we may be looking at a dead cat bounce in the spot price of gold (I am still

long) given the opacity of the Chinese financial system mirrors the opacity of the brown air which

surrounds it, sharply increasing private gold demand from China is the most important thing to monitor.

Demand is rising strongly. I smell some fear.

Sentiment and equities will likely deteriorate until Beijing steps in with a soothing liquidity injection of

some kind. I expect them to back off on the currency and to see some sort of confidence restoring

intervention soon. But that, while it has global implications, is not enough to flip over the applecart and

stomp it into smithereens. We now move on to our last – and most worrying – red flag of all.

“My, my, at Waterloo Napoleon did surrender

Oh year, and I have met my destiny in quite a similar way

The history book on the shelf

Is always repeating itself” - “Waterloo,” ABBA

5) NYSE margin debt reaches record high…again

A good barometer of leverage in the system and potential red flag for rising risk of “a cascade of margin

calls” at any market downturn, the NYSE margin debt level is an interesting metric to follow. Consider

the chart above.

As is readily apparent, this indicator was useful in the past by foreshadowing a market collapse. Yet as a

market predictor high margin levels are not foolproof, as this fool will try and demonstrate. Indeed, in

their report, “Red Flag!” written in August of last year, DB wrote the latest debt level figures published

of US$384 bn “…marked an all-time high since records started in 1959! In short, investors have rarely

been more levered than today!” I would point out one thing! The S&P 500 has risen 9% since then! (Ok,

enough with the Teutonic exclamation points). Margin debt now (as of January) is even higher: $445 bn,

up another 16%.

While the Fed determines margin rules, the last time they changed them was back in 1974 (when ABBA

won the Eurovision Song Contest with Waterloo). Stock purchase on margin then required a 65% down

payment and the Fed relaxed the rules to the current 50% level. With record low interest rates the

incentive to lever up now has probably never been higher. Also, note that in the US margin interest is

tax deductible (Uncle Sam so loves an indebted consumer). This may encourage higher margin debt

levels than were sustainable before.

Markets fell 6% in the US in short order last month but we did not see evidence of margin calls creating

more margin calls creating more forced selling until Armageddon swept us away. The sell-off usefully

did, however, release some pressure at the top which indicates potential for some further market gains

ahead.

Having said all that, this does not mean we can dismiss dangerously elevated margin debt levels as an

important indicator of markets gone too far. Margin debt is at historic highs and continues to rise as we

approach a “Minsky moment.” While we have examined and dismissed other warning signals that are

flashing, this one has the potential to keep me up at night. I would not, could not sell out completely

based on what just one metric is telling me but this indicator of clear and present danger makes me

nervous and like a Kiwi sailor, there are a lot of sheep in my dreams.

The Last Page

“Dear Abby” was the pen name of Pauline Esther Friedman, the most famous advice columnist in the US

for five long decades. Coincidentally, her twin sister, Esther Pauline Friedman, was also a famous advice

columnist, known as “Ann Landers.” Despite handily giving advice to all and sundry for the entire second

half of the 20th century on almost a daily basis, they hated each other…

Below are some actually letters received by Dear Abby.

Dear Abby,

A couple of women moved in across the hall from me. One is a middle-aged gym teacher and the other

is a social worker in her mid-twenties. These two women go everywhere together, and I've never seen a

man go into or leave their apartment. Do you think they could be Lebanese?

Dear Abby,

What can I do about all the Sex, Nudity, Fowl Language and Violence on my VCR?

Dear Abby,

I have a man I can't trust. He cheats so much, I'm not even sure the baby I'm carrying is his.

Dear Abby,

I am a twenty-three year old liberated woman who has been on the pill for two years. It's getting

expensive and I think my boyfriend should share half the cost, but I don't know him well enough to

discuss money with him.

Dear Abby,

I've suspected that my husband has been fooling around, and when confronted with the evidence, he

denied everything and said it would never happen again.

Dear Abby,

Our son writes that he is taking Judo. Why would a boy who was raised in a good Christian home turn

against his own?

Dear Abby,

I joined the Navy to see the world. I've seen it. Now how do I get out?

Dear Abby,

My forty year old son has been paying a psychiatrist $50 an hour every week for two and a half years. He

must be crazy.

Dear Abby,

You told some woman whose husband had lost all interest in sex to send him to a doctor. Well, my

husband lost all interest in sex and he is a doctor. Now what do I do?

Cheers.

Derek Hillen, CAIA

Mirae Asset Securities