In June of 2009, in a piece called "
," we argued that increasing the amount of money held in the bank
of a Monopoly game will not affect the game unless the players are
given more money at the beginning of the game or sometime during
the game. For this reason, we felt that those investors (and they
were numerous) who were avoiding US stocks out of inflation
concerns were making a mistake at that time.
In October of 2010, core inflation came in at zero and stocks
are higher. Unfortunately for most worldwide investors and asset
allocators, another Monopoly game has been played in China. Ben
Bernanke, Jim Chanos, David Barboza and Jason Zweig understand this
and are explaining it to folks who are willing to listen.
China increased their money supply aggressively in 2008-2010
like the US and many other countries suffering from the "Great
Recession." The difference in China is that it is a totalitarian
communist government and its capitalistic economy is built by
giving ownership of businesses and real estate development to
powerful communist party members and army leaders. When the
increase in the amount of money in their banking system occurred, a
simultaneous mandate came down from the central government to build
homes, commercial properties and infrastructure.
In the US, nobody was interested in borrowing the money. The
increase in the money supply is only inflationary if it turns into
loans and economic activity. The so called "money printing" in the
US caused a big decline in interest rates which reduced financial
stress on households and businesses. As the media has well
documented, it didn't lead to an uptick in lending or economic
China is a completely different story. Jim Chanos provided the
following information to Bill Powell at
Bank lending in China over the past two years has exploded:
Lending is up 95% year over year in 2009 vs. 2008, and up another
60% through the third quarter of 2010. And off-the-books bank
lending to local government finance companies might have been as
much as $1.6 trillion from 2004 to 2009.
They placed money from their banking system into the hands of
the folks playing Monopoly. If you've ever played the game, a
doubling of the amount of money that the players start with speeds
up the process of buying properties and the creation of monopolies.
The resulting inflation causes bankruptcy to occur quicker and the
game to be expedited. China's developments are designed to keep the
façade of uninterrupted GDP growth going. This in turn postpones
the day of reckoning when the Chinese people decide if they like
the downside of capitalism as much as they like the upside. We call
it the BRIC trade.
On top of a development cram down, the Chinese government has
also pegged its currency to the US dollar. In Frankfurt on November
19th, US Federal Reserve Chairman Ben Bernanke explained to his
audience how disruptive this peg is to international monetary flows
and commodity prices. Essentially, economic theory teaches that a
country which runs large balance of payment surpluses would see
their currency appreciate. This makes their goods more expensive
and slows economic growth in a natural way.
By pegging their currency to the US dollar, China has
effectively forced the US to pay inflated prices for oil, copper,
iron ore, gold and a host of other commodities while they cram down
the Monopoly money. We have the commodity prices in the US now
which you'd expect from a robust recovery in the US economy and
dramatically lower unemployment rates. All the emerging markets
which have pegged their currency to ours have effectively hijacked
our liquidity. Internationalists want to blame these imbalances on
the US money supply increases, because they all want to kowtow to
the Chinese government and maintain oddly inequitable business
Jim Chanos also kindly pointed out in the November 17th
blog that the monopoly money cram down has reached ridiculous
levels. His folks have calculated that 66% of GDP can be tied back
to these politically mandated games. Here is what Bill Powell
Housing prices are down in major cities while supply is
growing: New residential real estate investment alone accounted
for 14% of China's GDP in 2009, and housing prices have started
to come down, though the overall supply is still growing sharply
in 2010. Even Goldman Sachs forecasts a 10% to 20% housing price
decline between now and the end of 2011.
Chanos' firm, Kynikos, also has evidence that the frenzied and
somewhat mindless home purchases are seeing a big sales drop from
last year. For those of you who got caught in our real estate
bubble, the sales drop off preceded the prices collapsing. David
Barboza of the New York Times played Toto for us and pulled the
curtain back on the Wizard of Oz in China. The Monopoly money has
created a number of "Ghost Cities" and empty developments all over
China (New York Times article "Chinese City has Many Buildings, But
Few People" October 19, 2010).
Lastly, Jason Zweig put the effects all this has on the US stock
and bond markets together in the November 20th edition of the
weekend Wall Street Journal. His article was titled, "Why Your
Stock Portfolio Is Acting Like a Commodity Basket."
Zweig confirms what we at Smead Capital Management have believed
for a long time. Our belief is that the mass acceptance and the
belief of worldwide investors in the idea of uninterrupted growth
in China and other emerging markets have created distortions in the
US stock market. These distortions might be bigger and more
all-encompassing than the tech bubble. Here is what Mr. Zweig
Some of the linkages between stocks and commodities are
looking bizarre. This Thursday, the monthly correlation between
sugar futures and the S&P 500 hit 67%, more than 10 times its
level just six days earlier, says Howard Simons, strategist at
Bianco Research. That is the third time this year that the
linkage between sugar and stock prices surged above 60%-much
higher than their long-term average of under 20%.
Another group of commodities-industrial metals-seems to be
exerting a magnetic force on some unusual targets. According to
global portfolio strategist Phil Mackintosh of Credit Suisse, in
recent weeks, shoe manufacturer Nike and fast-food giant Yum
Brands both have been moving around 60% in lock step with the
prices of aluminum, copper and zinc. Those correlations have
roughly doubled since May.
But there is another, less visible force at work, Mr. Simons
says. Algorithmic trading programs, or "algos," automatically buy
and sell a wide variety of assets based on mathematical models.
An algo doesn't know or care why two assets are moving together;
it merely is programmed to recognize that they are doing so. As
soon as a computer places bets that such a linkage in prices will
persist, other traders-computers and humans alike-tend to take
note and follow suit. That can be true, Mr. Simons says, whether
or not a correlation is driven by fundamental economic
"We've gotten to the Frankenstein point where algos are
self-programming, and they evolve to chase these relationships,"
Mr. Simons says. "That's created a sheer wall of money that is
forcing other people's behavior into the same pattern."
We would agree that the use of monopoly money in China and the
mass belief in uninterrupted growth in emerging markets has reached
the "Frankenstein" or just plain silly stage. We remember how
ridiculous investor faith became in the idea that the internet
would change our life. Investors didn't know or care when a
"dot-com" company would have meaningful sales or profits just like
Chinese government officials are not worried about David Barboza's
"ghost cities." The Northern Telecom Corporation made up 70% of the
market capitalization of the Toronto Stock Exchange at the top of
the tech bubble in early 2000. Fidelity's Rising Dividend Fund had
a 20% position in tech stocks in late 1999, even though none of
them paid a dividend. The bear market that followed decimated
technology stocks. How crippled will widely diversified investors
be when emerging markets, commodities, commodity-related stocks,
heavy industrials and resource exporting country currencies all
turn incredibly sour at the same time?
Emerging market monopoly money has had a very damaging effect on
the duration of common stock investing. Investors in good quality
companies which have very little to do with emerging markets or
commodities are being tossed around by high volatility and these
high standard deviation price movements. Zweig quoted Howard Simons
on this subject:
The longer your time frame as an investor, the greater your
risk tolerance has to be now, because over the short term
diversification is going to keep looking as if it's disappeared.
It will re-emerge with time, though.
We believe that investors in the BRIC trade are about to find
out that what John Maynard Keynes said many decades ago is true. He
It (investing) is the one sphere of life and activity where
victory, security and success is always to the minority and never
to the majority.
Youku vs. Tudou vs. the Other 'YouTubes of