On February 4 the Year of the Tiger transforms into the Year of the Rabbit, if you believe in Chinese horoscopes. According to the Chinese zodiac, the “Rabbit” is going to be a walk in the park compared to all the excitement of the past two years.
Of course, when you consult with soothsayers it’s a good idea to read around a bit and get a second opinion. In this case, the second opinion comes from my own postlast year on bubble dynamics.
The big idea:
- It is possible to recognise bubbles.
- It's also possible to figure out how big they are (and how far they will fall).
- Post-bubble dynamics are predicated by the bubble that happened.
1. Gold
I’ve been saying gold is a bubble that's been building for over a year. That line was based in the first instance on the historical relationship between gold prices and oil prices (at $90 oil, gold “ought” to be $850 by that benchmark). So either gold is a bubble, or oil is under-priced (at $1,400 it “ought" to be $150), or what’s happening now is a new paradigm.
Personally I’m a bit suspicious of new paradigms; I seem to remember that’s what they said about housing. Particularly since the logic behind stratospheric gold is that the Fed is printing a lot of money, but yet, in the grand scheme of things, the Fed didn’t print a lot of money.
The $1.25 trillion for TALF was supposed to have been secured by assets, which the Fed says will turn around. That’s an interesting concept, given that the problem with TARP and PPIP was that the genius bureaucrats couldn’t figure out how to value a toxic asset. Looking at it another way, that was just an exercise in forbearance, which says the problem was not about solvency but about liquidity.
Either way, $600 billion for QE2 was chump change in the current scheme of things; you can’t even have a decent-sized war with that amount of money.
I got to a “second-second opinion” on gold looking at U.S. trade deficits and how they are financed. Interesting that since 2000 or so, the price of gold tracks the cumulative amount of toxic debt that the U.S. sold to foreigners to finance its trade deficit.
That’s until about 2007, when the line which had up until then a 95% R-Squared -- diverged, which is symptomatic of a bubble. Intriguingly, that line of logic also says the price of gold now “ought” to be around $1,100.
So perhaps oil is a bit undervalued, and gold is a bit pricy for now (although no one agrees with me on that; I have been wrong before); either way, I suspect that in 2011 all may be revealed.
But I confess, I’m not so convinced about my logic to short ... although I’m also not long. As a matter of principle, I try and stay clear of things I don’t understand.
2. Oil
The bubble model presented 18 months ago, which said in June that by December 2010 oil should be flirting with $90, appears to be holding up pretty well ... although according to that model (re-jigged a month ago), the “correct” price of oil now is $85 not $90.
That’s of course assuming there isn’t a new paradigm in the wings … something to do with the idea that within 15 years someone is going to have to discover 40 million barrels a day of new capacity (currently the world uses about 70). And when that penny drops, if oil costs more to pull out of the ground than hoped, then quite soon it ought to start to be priced in reference to its replacement cost -- not on how much you can squeeze out of everybody.
Intriguingly, the Saudis, who say they have the power to control”oil prices (“if necessary”), are now saying that $100 is “fair” -- reassuring, except that six months ago they were saying $75 was fair.
It’s hard to see how you can miss investing in that one going to its logical conclusion, although I suspect an investment in diesel made from corn might be risky. At some point one of the geniuses in Washington might wake up to the fact that that uses more energy than just refining the standard stuff you pump out of the ground.
3. Toxic Assets
I was intrigued to see that in the third quarter, sales (to foreigners) of U.S. securities other than U.S. Treasury securities rocketed from -$123 billion in the third quarter of 2008 to +$108 billion in the third quarter of 2010. That’s what you and I call “Toxic Assets”; you can find those numbers on Line 66 of “U.S. International Transactions Accounts Data,” which is on the BEA website.
Not many people know this, but America and the dollar were kept afloat from 2000 to mid-2008 in spite of racking up $3.0 trillion in cumulative trade deficits (in goods and services), because -- and only because -- of the wonders of securitization. Over that period, Goldman Sachs (GS) and others sold $3.5 trillion worth of “toxic" to Norwegian pension funds, RBS, and to other not-so-smart foreigners. That financed the shortfall in the trade deficit and thus kept the mighty dollar mighty.
All good things come to an end, however, and the not-so-smart foreigners wised up a bit and stopped buying ... which is one reason there was an “almost depression,” because no one could do the roll-over trick anymore. The situation was compounded because the less nimble “shadow banks” couldn’t offload their inventory fast enough. Goldman, of course, did manage to clear most of its inventory in time, in part by creating synthetic collateralized-debt obligations with names like ABACUS.
What’s really interesting right now is that the $108 billion of toxic sales to foreigners, in the third quarter of 2010, was of a magnitude similar to what Tim Geithner managed to sell directly and indirectly to foreigners in that same period ($195 billion).
As was explained earlier, from 2000 to 2007, foreigners bought (net) $3.5 trillion of toxic, but they only bought (net) $2.3 trillion of Treasuries. The difference, of course, is that if the U.S. government defaults on its Treasuries, that’s serious, as that would be a sovereign default ... but when the clients of GS and the like default on the toxics, all that happens is you go back in the accounts and call those "exports,” and you send the Norwegians a little note saying “Oops, sorry … but any time you would like to collect your collateral (10,000 fixer-uppers in Detroit), just come on by."
Prediction: In the Year of the Rabbit, foreigners will buy $500 billion of toxic assets in America.
One of the reasons for that is because the Fed has stopped propping the price up to unrealistic levels through its TALF program; now there are deals to be done ... although buying that garbage is often a blind gamble, because the information you need to do a proper valuation is simply not there.
There again, because of that, they are going cheap -- real cheap. That’s what bubbles are about: First the gamblers pay too much (like Lehman did), then, as now, they get to pay too little, as the “mal-investments” get flushed away.
The good news is that the $500 billion ought to be enough to finance the U.S. trade deficit in 2011.
4. U.S. Trade Deficit
It’s hard to predict what the U.S. trade deficit will be, but assuming oil will average $100 and that the “hot-money" recipients will run out of ideas on how to keep out American exporters, you can pretty much eyeball that:
Prediction: In the Year of the Rabbit, the U.S. trade deficit will be $500 billion (round numbers).
5. The Dollar
With an itsy little trade deficit of $500 billion, compensated for by a $500 billion fire-sale of toxic, it looks like the Austrians are just going to have to grin and bear one more year of the greatest fiat currency in the history of mankind. Particularly since the only contender, the (once) brilliant new-look fiat currency known as the euro, is discovering that it’s much better to sell toxic than to sell sovereign if you want to raise money to keep your economists, politicians, and bureaucrats in the lifestyle that they have become accustomed to.
6. U.S. Treasuries
If ever nominal GDP in the U.S. starts to take off, U.S. Treasuries will too; I’ve got the 10-year pegged for 3% in March (now it’s 3.4%), and plenty of people think I’m wrong.
I say there was a bit of a bubble after the rumor got out that there would be QE2 and the dealers played with Ben Bernanke like a cat with a mouse by front-running the price. Here’s a tip, Ben: If you want to spend $600 billion on something, don’t tell everyone first.
7. S&P 500
Still post-bubble, and thus about 20% under-valued, the S&P 500 will be driven by nominal GDP in the U.S. plus in the rest of the world (50% of S&P earnings are outside the U.S. now), and by the 30-year yield.
Uninterestingly (from a bubble perspective), the money in equities now is picking good companies, not playing the bubbles, so look for 10-15% growth in the index for a couple of years. It won’t go down below 1,100, and even if it does, it won’t stay down long.
I’d say U.S.-listed stocks right now are one of the safest medium- to long-term investments around ... plus there is the added advantage that regulation, if spotty, is still pretty good -- which is more than can be said for places like India or China.
8. U.S. Housing
15% more to go (down) on the S&P Case-Shiller, unless inflation seriously kicks in, which is unlikely; good time to buy.
9. Hong Kong Housing
My prognosis in January 2010 was the Hong Kong property was not a bubble, and it went up by about 20%, which is certainly not a bust ... although with nominal GDP “only” growing at 9%, that’s starting to look bubbly.
10. Dubai Property
The bottom of the mispricing was last year, but prices are still going down due to new inventory. Commercial space, particularly offices, is dire; still, it’s a good time to buy if you can find anything decent ... although prices of good stuff are up on last year. The economy will improve thanks to higher oil prices, and whoever it was that borrowed that $100 billion has cleverly made sure it’s not on the Dubai government’s balance sheet, so everything still works. Whose balance sheet it’s on is still a mystery, although the rumor is that the lenders took a haircut -- and their treat for the Year of the Rabbit will be to take a bath.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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