Tuesday, June 28, 2011

Invest For Inflation

Economies tend to act in a cyclical fashion. Cycles caused by statistical randomness or due to human behavioural or other patterns. There are additional factors that influence stock markets and economies alike, such as psychology and evolution or the finite amounts, no matter how large, of world resources. For years we have hoped to profit from the rapid economic growth of the BRIC countries and today the expectation of continued growth is by most taken for granted. Despite the enormous growth of emerging economies, stock market returns over the last decade have been muted. This often caused by investor's tendency to pay too much for obvious growth. This was true for the high tech boom in early 2000 and it is true for investing in the current BRIC boom.

Today economic growth in China and other emerging countries is coming back to earth. China's competitive advantage - low labour costs - is disappearing. Commodity prices are rising, in spite of IEA intervention. Higher energy prices are here to stay but they are capped by the economy's ability to grow. Once the fog of high government indebtedness clears the world may have yet changed again in a dramatic fashion.

I see over the coming years that Canada will become the resource oasis for commodities; one of the few places where private investment, political stability and business friendly policies still reign. At the same time, China and its emerging brethren may revert to a centrally planned economy focussed inward on their domestic markets and aimed at satisfying their populations' demands for a social safety net, for better wages and for a better lifestyle. This has happened to many countries before - Japan being the quintessential example. Where in past decades cheap labour created astronomical 'productivity gains' felt throughout the world and that helped significantly reduce inflation worldwide, now the opposite is about to happen. Yes China's economy will likely keep on growing at 6 to 10% for some years to come resulting in an ever increasing commodity demand and in an increasingly more expensive labour force. These are factors that will feed worldwide inflation. Technological innovation will likely continue to improve productivity but not enough to offset these inflationary forces.

To combat increasing transportation costs, in the Western world local industries are likely to flourish and globalization may slow down or retreat. However, a retiring Baby Boom generation likely will result in labour shortages and higher wage demands in both Europe and North America. Add to this the high levels of government debts, the costs of a war in the Middle East (Libya, Syria?) plus a winding down war in Afghanistan and we see even more inflationary pressures.

Finally there is the Middle East. The Arab Spring is just the beginning of major social changes in that part of the world. The Arab population also wants to enjoy life's luxuries and it will consume an ever increasing share of its oil resources. Resources that already today can barely keep up with world demand and that start showing clear signs of depletion.

All of this will likely lead to higher inflation. Ironically, the U.S. and Canada in its tow may become the real winners. The U.S. is one of the world's most desirable immigration destinations. Thanks to its numerous illegal immigrants the U.S. is demographically one of the world's younger countries. So is Western Canada. The U.S. with its entrepreneurial spirit combined with a young population and relative low government intervention is optimal for innovation and for improving productivity just like Canada - in particular the West. In the meantime, China is increasingly returning to a planned economy. Governed by a few who are trying to control the population, China faces a continuous rise in the cost of living. The stifling of innovation inherent to central planning and the increasing cost of living will handicap China severely and it will reduce its competitive edge visa vie the U.S. further. The short term nimbleness of central planners due to a shorter line of command hides the long term inability to adopt because central planning stifles the multitude of opinions and initiatives that exists in China's population.

On the other side, the U.S. and Canada have what only few in the world have - natural gas and oil in relative abundance, water, large reserves of resources such as potash and numerous other commodities and the freedom to follow our dreams. We are having affordable energy, fertilizer and water plus a young population filled with new ideas and endeavours. No wonder, that Warren Buffett expresses his bullishness on North America. So count on high inflation, the return of manufacturing, innovation and plentiful resources that will ensure the resurgence of North America and that will power the North American stock market in the years to come.

Monday, June 20, 2011

The Buck Stops With You

The case of Sino-Forest, the Chinese Forestry company and its sudden collapse of share price following the maligned analysis by short seller Carson Block of Muddy Waters LLC illustrates the problems stock investors face. This is not the first scandal with overseas operating companies that are listed here in North America. Just think of Bre-X and many companies that operate in emerging countries and have their 'head quarters' here.

It is all about transparency. The dealings of Sino-Forest are so muddled that even Globe and Mail Reporter Mark MacKinnon could not verify the existence of some of Sino's subsidiaries, offices and partners when send out on a two week fact finding mission. If 'facts' are so difficult to verify do why Canadian regulators allow the listing of such a company on one of our premier stock markets? Nor does it seem that many of the 'Analysts' at Canada's major brokerages and investment establishments, who have over the past promoted and recommended this company to its clients taken any responsibility for their recommendations.

It seems that the Canadian investment industry is fine with collecting underwriter fees and trading commissions from an unsuspecting, trusting clientele but that it wrings its hands in feigned concern about the losses its duped clientele suffer but no more. That is as far as their accountability seems to go. The next day you hear the same talking heads on BNN telling you with the greatest confidence what other investment gems their 'exhaustive' research has uncovered. It is all about making money, yeah their money, at the expense of a trusting public.

Whether a sham or legit, the Sino-Forest affair reduces the credibility of Canada's investment institutions to virtually zero! How is it that an army of 'experts' often with little real investment experience other than a few equations and algorithms learned in business school or, heaven forbid, during the Canadian Securities Course, are allowed to advice investors whose life savings and net worth many times exceed that of those 'experts'. "Mr. Expert, if you know all this so well, why are you not a millionaire rather than trying to sell paper certificates to me from a small cubicle?" is a question that definitely comes to mind.

It also illustrates once again, that stock market investing is not much different than investing in corporate debt. The investor has no real control and he/she has to believe the board of directors and the officers of the companies he/she invests in on their word. After all, those expensive third party accounting audits turn out to be worth less than the paper it's written on. If you invest in stocks, you basically get a share of the profits and often those profits are reinvested in the company (without you seeing a penny) until the day 'your' company goes broke. Or, when lucky, you make a profit by selling your shares to the next sucker. Sometimes this business seems to be a gigantic Ponzi scheme rather than a legit investment. That is why it is so important that investors get dividends, because then, at least, you do get a 'real return' on your money.

There are many good managers and employees that run many legitimate, profitable, companies. You, the shareholder can make money of that in return for providing equity. However, when all is said, your investment is not much more than a loan without an expiry date and you have absolutely no guarantee that you will ever see your money back!

Investing is not for the faint of heart. Corporations, management, banks, stock brokers, Realtors, lawyers, analysts, accountants, they are not in this business for you. They sell you their services so they can make a living. When all is said and done, the buck stops with you! Never, ever forget that!

Thursday, June 16, 2011

So it is a correction!

So it is a correction! Well what else is new? Look at the chart below and you can see that we haven't had a significant set back since March 2008 when the bear market bottomed. Since March 2008 we have gone up from 7800 to today's 13000; that is a 5200 point gain or a 67% gain! If you'd counted from March to the April peak of 14300 then we had a 6500 point gain or a 83% gain from the market bottom. Thus we dropped 10% from the peak that is a normal correction, not the end of the world.

Yes some parts of the world economy are mired in trouble like Greece and the U.S. and the U.K. Living here in Alberta at the beginning of yet another boom one does not feel today's economic pain and you want the market to rocket ahead. But reality is that some of the 2008 problems won't go away that easy and even after a two economic aspirins (QE and QE2), the pain will fade only slowly.

Consumers have woken up to the havoc created by debt used to finance their lifestyle. Using debt to finance a business or part of an investment portfolio is often highly beneficial. But spending borrowed money on vacations that give you no other return than instant gratification is economically not wise. Consumers have seen the light and are trying to reduce their debts; but reducing debt is a though job and savings go hand in hand with less consumption! It is amazing how even-handed consumers are. The savings rate in the U.S. has gone up to 4% and thus consumption has gone down (offset by a growing population). Yet consumers have not adapted the 8% savings rate of earlier decades and consequently spending has moderated not disappeared all together. I don't think we could ask for much more!

Greece is a small economy that has always been in economic dire straits similar to Spain, Portugal and Italy. These countries haven't been economic powerhouses for over a century! And what do a couple of hundred billion mean in the greater scheme of things? The Europeans are working out the issues, and I am convinced they will succeed in spite of the shrill utterances of U.S. rating agencies, who feel that they can even dictate what government should rule Belgium! Talking about Fitch and their arrogant peers; they must have completely forgotten how their 'expertise' played such a disastrous role in the financial collapse of 2008! Pppplease! The gal!

In the meantime, the economic growth in China and India has been too high and inflation is picking up it's ugly head. Although average inflation numbers may seem benign (around 4%), poor harvests and other natural disasters along with a growing and more prosperous world population have driven food price up by more than 11%! With so many low wage people in those emerging countries is it any wonder that we're getting food riots? The Chinese have increased capital requirements for their banks as well they have increased interest rates. They try to reduce the availability of credit and to slow down their economy! GDP growth has already moderated from 10% plus to now around 9%. But even if it would cool down to 6%, their economy  still grows and their demand for commodities will keep on increasing.

So in the U.S. we will have to learn to live with a more moderate pace of consumption. The high U.S. debt will probably translate in a lower dollar value, which will make U.S. manufacturing more competitive. North American manufacturing will also benefit from higher energy prices. It will become more expensive to transport manufactured goods from all over the world. The low wages of the BRIC economies won't be enough to increase the cost of transportation. Consequently, globalization in manufacturing will slow down and jobs will stay closer to the major population centers. Thus there is good and bad!

Especially combined with a shortage of workers now that baby boomers reach retirement age (this shortage will also be less than many alarmists assume) wages may show real growth. Reduced consumer debt in North America will set the stage for big windfalls by local industries that champion productivity increases through technological innovations. With manufacturing returning to North America, we will also have more control over our emissions and energy consumption – a good thing for the environment.

To me it doesn't look like the world is coming to an end but instead economic patterns are changing with many positive consequences. The recovery will continue and prosperity will return. Use this correction in the stock market as a time when stocks are 'on sale'. Buy industry leaders in manufacturing, technology, energy, mining and real estate because over the long term they're likely to perform well. BTW, I read a forecast that by 2020 50% of North America's population will suffer from diabetes type II due to our increasingly sedentary lifestyle and gluttony. So don't forget to invest in the pharmaceuticals and exercise a lot!

Saturday, June 4, 2011

We all blame the Great Recession on the Banks but is that really justified?

We learned that high oil prices affect economic growth. If Oil today would rise above $125 as posted earlier, then we're likely to experience an economic slowdown. So what caused the economic boom of the 1990s? High Tech? Easy Credit and overconfident bankers?

No, a lot can be attributed to an abundance of resources. This may include not only an abundance of commodities but also an abundance of people (labour) and an abundance of productivity growth. In the 1970s commodity prices were high; I remember not only the oil price shocks and high gold prices but also the high price of coffee. Inflation was high, government deficits grew and grew, interest rates soared and the economy was sluggish, unemployment was relatively high. In the end, to find work, I emigrated overseas to a commodities paradise: Calgary, Alberta. But Canada's federal government tried to control inflation and disperse prosperity more evenly. With the bulk of Canada's political power in the East where they all eyed enviously the 'gold paved roads of Calgary', the National Energy Program was unleashed. That combined with inflation fighter Paul Volker in the U.S., oil companies such as Dome which paid nearly 20% interest on its over extended debt laden portfolio and the onset of the 1982 Recession spelled the end of the commodity boom.

Calgary's resource economy collapsed but once inflation reached more reasonable levels, Ontario's industry and industries in the U.S. started to prosper. Commodity prices and inflation continue to fall and manufacturing boomed. With energy prices low, and plenty of baby boomers in the work force, manufacturing boomed and so did housing and banking and High Tech. Productivity did not only increase due to low energy prices, but also due to the rise of computers. Inflation kept falling and with India and China adding to cheap labour, prosperity occurred everywhere while commodity based industries suffered – not only oil but also mining, agriculture and to a lesser degree forestry. Ever falling inflation lowered budget deficits which in turn lowered inflation and thus interest rates fell to unheard of levels. Real Estate and stock markets boomed especially in industrial economies like Europe, the U.S. and Asia. But with all this growth the demand for resources increased, yet nobody invested in those money losers!

Around 2000 the inevitable happened, commodity prices started to rise. At first nobody cared and manufacturing grew along with a recovering resource industry. So did real estate and in Western Canada, in particular in Alberta, real estate prices started to catch up with the rest of Canada. But the resource industry could not keep up with energy demand and the demand for other commodities and prices skyrocketed. Being used to low inflation and ever falling interest rates, the banking industry became increasingly creative in inventing fixed income instruments, derivatives and other financial products. Being used to an ever increasing wealth and prosperity, the financial industry threw caution out of the window encouraged by investors demanding every increasing corporate profits. Then we hit the wall, suddenly we realized how short on resources we were. Commodity prices shot up beyond what was sustainable and manufacturing and many other sectors could no longer afford expansion and profits disappeared. No new loan demand, a declining real estate market during uncertain 2007 and then the excesses of the financial industry came home with a vengeance. The Great Recession had arrived.

Now we are in a new era of high commodity prices. We become suddenly green, while in the previous era of cheap energy we couldn't wait to buy ever larger SUVs and houses. Once again we are experiencing large budget deficits and countries not being able to pay their debts. The story is starting to repeat. To speak of Robert Jordan's Wheel of Time where Ages come and pass! But our ages are short and we can learn from our mistakes of the past. Hopefully we can control the damage not only here but also in Europe. I am an optimist and although inflation and energy prices will continue to rise and economic growth may be a bit less vigorous, we will continue to prosper.

I think that the Great Recession was not only caused by the greed of corrupt bankers, although they did get out of line. However, the Great Recession is clearly part of a bigger picture. I do believe in the limitations of our resources but I also think we will be able to overcome these issues by building a more sustainable economy and eventually we unavoidably will branch out to the next frontier: the new wild west of space. For now we will have to deal with high energy prices and we will need other forms of energy to keep energy prices reasonable enabling our economy to grow.

Yes, our resources are limitless but their cost will increase. We will not only have to control the size of the human population but we also will have to develop a new form of economic growth. Our material needs will stabilize – how much bread can one eat? Profits and productivity will have to come from an economy no-longer based on population growth and ever increasing material demands. A whole new form of thinking, a new economic paradigm, will be required and this includes also how we will look at 'work' and 'labour'. May we live long and prosper. And, yep we can't just blame the bankers [or the oil people] for all our troubles, in fact we will have to start with ourselves.

Calgary’s Housing Prices Driven by Oil Prices and Inflation

Dean Baker was quoted in Globe investor as saying that housing prices over the long term (100 years) follow inflation. The Globe called Mr. Baker "The Man Who Called the Last Two Bubbles". If it earns distinction to call right two major bubbles, then I guess us less enlightened souls have no chance to call right a run of the mill recession or market crash. So much for market timing!

Everyday we're hearing that we're living in bubbles and thus that we must live a bubblicious life! But are we in Calgary living in a housing bubble? What is an appropriate price for an average single family dwelling? We discussed already that property pricing lies in the eyes of the beholder and that a real investor looks at pricing quite different than someone who is buying his/her dream home.

But the true value of property prices is ultimately determined by the market. So I pulled out the old graph to see if Dean Baker's observation that long term property values do trace inflation makes sense. The graph is shown below:

Calgary's average single dwelling price versus time. The slope of the blue line represents approximately 4% which is close to Canada's 40 year average inflation rate of 4.6%

Starting in 1973 up to today, a 38 year time range, the average annual price of a single family dwelling in Calgary increased at 7.95% per year. But not at a steady pace! Look at the graph again; you may notice that the price trend can be subdivided into 3 segments:
  • 1973 – 1982
  • 1982 – 2005
  • 2005 – today
If you calculate the average price increase between 1973-1982 and compare it with 1982 (after the crash) to 2005 it can be concluded that they were more or less the same: around 4% (slope of blue line) which is close to Canada's average inflation rate over the past 40 years (4.6%). So what caused the crash in 1982 and the upturn from 2005 to 2007? Duuuh! The oil price! In 1982 the oil price crashed from an all-time high that had been building all through the 1970s.

From 1982 until 2005 were Calgary's 'misery' years when the rest of the world boomed due to falling inflation and low commodity prices, including oil and gas. If you think $4.25 per mcf for gas is low then check natural gas prices in the 1990's when we got excited about $1.50 per mcf!

It looks to me that Calgary is still an oil town and that real estate prices are governed by inflation and that sudden jumps or crashes reflect commodity price trends, in particular those of oil and gas. So provided that commodity prices hold, our real estate prices will likely increase at a rate more or less equalling the inflation rate (long term). With a new long term period of increased inflation likely ahead, real estate investments should provide a good hedge (barring another major oil price crash). I guess if you look at a glass being half full, you may want to say that we may expect a significant bump upwards when gas prices recover
A final lesson to be learned is the notion that if you break even between rental income and operating costs, you'll do OK in real estate. But if you really want to make money you need leverage. The reason is simple high school math. Without leverage your property value increases with inflation, i.e. you don't win nor lose in purchasing power. But assume your $100,000 property increases with inflation of say 4.6%, i.e. by $4600 per year, and you have a mortgage equal to 80% of your property value (Loan to [property] Value = 80%) then your own money invested is only $20,000. A profit of $4,600 would then represent a return of 23%!

Conclusion: in times of inflation leveraged real estate may be hard work but it also will proof to be very profitable.