Aggregated Awareness

Today, the Reserve Bank of Australia meets for the first time this year. I’ve spent the last week reading the papers as they make a case for a rate cut this week.

Most papers are keen to analyse the data you’re familiar with, like gross domestic product, retail trade data and inflation-related data. But they ignore another measure of our economy that I believe is a very good indicator of the action the RBA will take on rates.

The thing is, when this economic indicator goes ‘up’ interest rates tend to follow it higher… and when it goes south… well, a cut in the cash rate isn’t far behind.

Glenn Stevens, the governor of the Reserve Bank of Australia, mentions the ‘terms of trade‘ when a policy decision has been made. At the September 2011 meeting, he said it’s ‘…now at very high levels and national income has been growing strongly’.

And he referred to it again when the RBA cut rates at the December meeting: ‘The terms of trade have now peaked and will decline somewhat in the near term, but they remain very high.’

The terms of trade simply reflects the relationship between the prices of exports and imports. So an increase in the terms of trade reveals that export prices are increasing faster than import prices.

I bring the terms of trade up because of the effect it has on Australia’s economic growth.

It’s not the standard measure of economic growth you read about in the papers – GDP (Gross Domestic Product).

The terms of trade is another economic growth measure calculated by the Australian Bureau of Statistics – Real Gross Domestic Income (Real GDI).

The chart below shows these two measures of quarterly national income plotted against each other. GDP is the dark line and Real GDI the light line.

As you can see, when factoring in changes to the terms of trade, Australia’s economic growth is much more volatile. Since 2003, it’s been much stronger than the standard GDP measure would suggest.

Now, look at the chart again and focus on the last few years. Real GDI plummeted in 2008 and early 2009 as China’s economic growth slowed and commodity prices collapsed. But by the time China’s stimulus worked its way through the system, in addition to Australia’s own stimulus spending, Real GDI rebounded strongly.

On this measure, by mid-2010, Australia was experiencing its strongest rate of growth since 1997. Now that may seem absurd given the weak conditions experienced across large parts of the economy.

And yesterday’s retail trade data was the worst in decades.

Despite manufacturing data in January suggesting minimal growth, Toyota sacked 530 Australian workers. Reckitt Benckiser, the company that owns brands Mortein and Dettol shifted its production lines offshore, along with almost 200 jobs. And Westpac shed 560 workers.

And that was just one week!

But that growth in Real GDI was thanks to a soaring terms of trade. And the benefits were felt almost exclusively in the resources sector.

Governor Glenn Stevens is always talking about the terms of trade and its impact on national incomes. So I reckon the Reserve Bank looks very closely at Real GDI when setting interest rates each month.

That’s why rates were slashed in 2008 and then increased more than anywhere else in the developed world in 2010, in line with the sharp downturn and quick reversal you see in the chart above.

If we look at the fourth quarter data (not charted) it tells us that export prices fell 1.5%, meaning the peak in terms of trade is now behind us.

As a result, Australia’s Real GDI – our ‘income’ – has fallen. The further our Real GDI falls, the more likely the RBA will lower interest rates to offset the fall in national income.

You make think falling interest rates is good news. And that’s the way the media will portray it. But it wasn’t good news in 2008 and it won’t be in 2012 either. Falling interest rates are a sign the Reserve Bank has run out of ideas on how to keep the economy moving at the same speed we’re used to. And you should get ready for it to falter.

Greg Canavan
Editor, Sound Money. Sound Investments

From the Archives…

Facebook Shares – Notice for Mad Punters: Buy This Stock
2012-02-03 – Kris Sayce

Why Your Money is Better Off in Stocks Than in the Housing Market in 2012
2012-02-02 – Kris Sayce

Why You Should Pay Attention to the ASEAN Bloc
2012-02-01 – Cris Sholto Heaton

Will Australian Property Prices Keep Falling?
2012-01-31 – Dr. Alex Cowie

Is Ben Bernanke Secretly Buying Gold and Silver Stocks?
2012-01-30 – Dr. Alex Cowie

Could this be the most bearish statistic in the world right now?

Over the past month, one of the world’s key leading economic indicators has tumbled in value by 60%.

That’s not a misprint.

So what is the Baltic Dry Index (BDI) all about? And is this plunge something we should be worrying about?

The Baltic Dry Index Has Tumbled

The BDI is a key barometer of global freight activity. It’s published by London’s Baltic Exchange, the world’s leading market for buying and selling shipping contracts.

The BDI covers 26 major shipping routes. It measures the cost of transport space (shipping rates) on so-called ‘dry bulk carriers’. These carry cargoes of raw materials such as coal, grain, timber, steel and iron ore.

If the BDI rises, it indicates that shipping rates are rising, due to increased demand for transport space for raw materials. If more raw materials are being shipped, it suggests that factories are seeing higher demand for their finished products and so are planning to make more.

This makes the BDI a key leading economic indicator. Rising shipping rates suggest that manufacturing activity is improving, even before it shows up in the official statistics.

On the flipside, a drop in the BDI could suggest that worldwide demand for shipping space – and therefore, for raw materials – is falling. That in turn indicates that the global economy must be about to slow down.

But 2012 has already seen something much worse than a mere slip. The BDI has collapsed in just a month, as the chart below shows.

Source: Bloomberg

And if you drill into the details, the picture looks even bleaker.

Some of the world’s biggest ships are known as Capesize vessels. They are so called because they’re too big for the Suez Canal and have to travel around the Cape of Good Hope or Cape Horn.

Shipping rates for these vessels have plunged by an incredible 75% so far this year.

So is the global economy about to implode?

Bad News for Ship Owners

The answer isn’t quite that simple. For one thing, the BDI can be very volatile – much more so than the economy overall. Previous massive drops in the index haven’t always resulted in a re-run of the Great Depression.

That’s because the BDI isn’t just about transport demand. It’s also about transport supply. Remember, the BDI measures the cost of hiring space on a ship. So if you double the number of ships, then demand for raw materials could remain static and perfectly healthy. But shipping rates, and therefore the BDI, would (in theory) fall in half.

And the fact is that right now, there are far too many ships in the world.

Prior to 2008, when the global economy seemed to be booming, dry bulk ship owners got rather over-excited. They convinced themselves that the good times would last for several more years. So – pretty much all at the same time – they placed lots of orders for ships.

Many of those vessels have now been completed and are becoming available for hire. Extra shipping space equivalent to 23% of the existing fleet is due to be delivered this year, according to Macquarie Research. That’s “too much capacity in the face of more modest growth of trade volumes”.

In other words, it’s no great surprise the BDI has fallen back. What’s more, says Credit Suisse, there’ll be no respite from the oversupply of dry bulk ships until next year at the very earliest. Even then, the existing fleet will still grow by 9% as new ships are delivered. That could still be tough for the market to absorb.

Don’t Relax

Clearly, this is all bad news for ship owners. But surely it means that the rest of us can just ignore this scary message from the BDI?

Actually, no, we can’t. The trouble is that the extra ships aren’t enough by themselves to explain this plunge. As Louis Basenese points out on Wall Street Daily, the Harpex – an index of shipping rates for container ships, which carry finished goods – has also plunged, even although the supply of container ships is little changed in the past six months.

Meanwhile, Nick Bullman at risk consultant Check Risks tells Financial News that “this collapse looks similar to the falls we saw in the Baltic Dry ahead of the recessions of the late 1970s and early 1990s – but this drop is actually steeper.”

Continues Bullman: “this is signalling… that the world economy is slowing down much more quickly than people have been thinking.”

Why? It all points to China. The country is the biggest importer of raw materials and we know it’s slowing down. This plunge in the BDI is another reason to believe that China can’t avoid a hard landing. That’s bound to have a knock-on effect all around the world.

David Stevenson
Associate Editor, MoneyWeek (UK)

Publisher’s Note: This is an edited version of an article that originally appeared in MoneyWeek (UK).

From the Archives…

Facebook Shares – Notice for Mad Punters: Buy This Stock
2012-02-03 – Kris Sayce

Why Your Money is Better Off in Stocks Than in the Housing Market in 2012
2012-02-02 – Kris Sayce

Why You Should Pay Attention to the ASEAN Bloc
2012-02-01 – Cris Sholto Heaton

Will Australian Property Prices Keep Falling?
2012-01-31 – Dr. Alex Cowie

Is Ben Bernanke Secretly Buying Gold and Silver Stocks?
2012-01-30 – Dr. Alex Cowie

“What were you on about yesterday anyway?” a friend asked at dinner last night.

“With what?”

“The whole Glencore and Xstrata thing. Sometimes I can’t figure out why you put that stuff in your letter. It makes no sense.”

“Oh. Well, my point was that when you can’t figure out any other way to make more money, you announce a merger. It makes you look busy. Everyone gets excited. You say you’re creating more shareholder value. But really you’re just trying to find efficiencies or “synergies” to squeeze a bit of extra profit out of the business…because the easy profit growth is gone.”

“You should’ve just said that.”

Yep, we should have. So we just have. And today, more proof that the days of easy money selling dirt and coal to China are over. First cab off the rank is the Reserve Bank of Australia’s index of commodity prices. Have a look below.

What you see above is the biggest downturn in the RBA’s commodity price index since the big crash in 2008. Mind you it doesn’t look quite as severe, at least not yet. Last time around in 2008, the rush to cash in global markets caused people to sell a lot of their speculative commodity positions. Base metals in particular got smashed.

Base metals – lead, zinc, copper, nickel, and aluminium – make up 15.7% of the index, according to the RBA. Metallurgical coal (for steel making) makes up 14.7%, iron ore 9.3% and thermal coal (for power plants) makes up 9.7%.

If metals consumption in China is really peaking – the claim we made yesterday – it’s not hard to imagine the index crashing again. And if the index crashes again, it won’t be good news for base metals producers or explorers.

But let’s not be a Danny Downer. Oil is omitted from the RBA index. LNG is included (4.8%). But unconventional energy is not. In other words, a whole sector of the commodities complex that’s in a long-term bull market isn’t measured by the RBA’s commodity index. Do you realise what this means?

It means the RBA’s commodity price index can go suck an egg for all we care. If energy – oil, gas, uranium, and coal – is going to be the most important sector of 2012, the RBA index won’t tell you anything about it. All the RBA index will tell you is if base metals price crash and China’s metals demand has peaked.

We’ll be keeping an eye on it. But in the meantime, one more note about the RBA. It announces its decision on interest rates today. Will the bank cut the cash rate from 4.25% to 4.00%?

That’s an interesting question. But is it relevant? ANZ is just one of the Aussie banks to go on record and say that the RBA’s price of money isn’t what ANZ pays. See the 12 December 2011 Daily Reckoning for more on this. This is the banks’ way of saying they’re not obliged to match the RBA’s rate cuts point for point.

It’s kind of quaint to think there are some people in Australia who think the RBA actually controls the price of money. But some people do! Take Ged Kearney for example. He’s the president of the Australian Council for Trade Unions (ACTU). Kearney told the Herald Sun…

Last year the big four banks made profits of $25.2 billion – easily more than the rest of the banking sector combined. They now have a greater share of the home lending market than before the global financial crisis….If the banks cannot behave in a socially responsible manner, it may be time to consider stronger government regulation to drive greater competition, improved consumer protection and more sustainable corporate behaviour in the banking sector.

Heaven forbid that we’d defend the banks in this space. But someone might want to tell Mr Kearney that Moody’s has just released a report claiming that Australian banks are the “most exposed” banks in the Asia-Pacific to a worsening of Europe’s sovereign-debt problem. What exactly does that mean?

Before you go bagging out Moody’s for being an unreliable ratings agency that shouldn’t be trusted, consider the main point in the note. Moody’s isn’t worried about the amount of European government debt Australian banks own. That’s not the problem. The problem is that Australian banks get at least 19% of their funding externally.

In a genuine liquidity/credit crisis, external funding a) gets more expensive, b) dries up for all but the highest credit-quality borrowers. The cost of money goes up and there’s less of it to go around, in other words. This is why banking is a lousy business in a credit depression and why bank stocks make lousy investments.

By the way, we’d started to go into detail examining the current situation in Greece and Europe…but to be honest, we just couldn’t bear spending another precious second analysing a situation that’s so hopelessly doomed…and so cynically and horribly mismanaged. As our colleague Dylan Grice at Société Générale writes:

Flawed thinking got us into this mess. But rather than change that flawed thinking, our policy makers are applying it with even more rigour: we have more debt for insolvent borrowers, more financial engineering, more complicated banking regulations, more blaming speculators for everything, more monetary experimentation by central banks. Our policy makers have absolutely no idea what they’re doing, but they’re giving it a go!

Grice refers to the “Lost Pilot Effect”. That’s a term invented by behavioural psychologists to explain a certain kind of irrational behaviour. You see it when a pilot gets lost but tells his passengers, “I have no idea where we’re going…but we’re making good time!”

There’s no point in hurrying along somewhere if you don’t know where you’re going. And it’s even more insane to hurry along to a place where you don’t want to be! The best move, if you’re lost, is to get out a map and a compass and find out exactly where you are.

Hopefully Dylan will bring his map and compass with him to Sydney next month. He’s one of our four keynote speakers at the After America conference. We invited a thoughtful group of keynote speakers for our first conference for a reason. We want you to hear from people who can help will help you figure out where we are on the map.

The particular map we’ll be looking at is the Asia-Pacific region. The main players are China, the United States, and Australia. It’s a big map. It covers a lot of territory. There’s a lot to talk about. But hopefully the conference is small enough – only space for 344 attendees – that we’ll be able to really dig into some of these ideas.

By the way, we’re opening up the conference to the general public later this week. You can still get the early bird price of $799 for a few more days. After that, the price moves up to $999.

It’s been an eye-opener organising a conference around one big idea. One mistake we realise we made is not giving people enough time to make travel plans and arrangements. We won’t make that one again! In fact we’re already planning next year’s show.

Another concern is location. Up until now, all of our events have been in Melbourne because that’s where we are. We thought an event in Sydney would make it easier for readers in New South Wales and Queensland to attend. Hopefully we can have events in Brisbane, Perth, and Adelaide too. But maybe not this year.

Price is an interesting one. One friend told us that for the line-up we had put together and the small crowd and the number of new ideas from Port Phillip Publishing editors, the price seemed too cheap. Another financial professional told us that when you factored in travel and hotel arrangements, the price was too expensive.

Either way, this is not a money-making venture for us. For five years we’ve been having a conversation with you about Australia’s future. We thought it was high time to set aside a few days, invite some guests, and really talk about it, including some specific ideas. It’s going to be a cracking show.

One of our other keynote speakers is Dr. Paul Monk. Like Dylan, Dr. Monk is interested in how we think, how we make decisions, and the quality of our knowledge. In the article below, he reviews Daniel Kahneman’s latest book on how we think.

The Brain: A machine for jumping to conclusions
By Paul Monk

Daniel Kahneman’s Thinking, fast and slow should be required reading for everyone this summer. Not because it is entertaining or a mere diversion, but because it is a subtle and beautifully scientific guide for the perplexed. If you see yourself as a citizen in a democratic polity, read this book. Self-indulgent cynics and self-important ideologues probably won’t read it, but they are the ones most in need of what it has to teach. Do yourself a favour, whoever you are: rush out, buy this book and read it quietly and thoughtfully, absorbing its highly readable insights.

Kahneman was awarded the Nobel Memorial Prize in Economic Sciences in 2002 for his work on prospect theory. To understand what is meant by this, how Kahneman got into thinking about it and what his key insights were – in collaboration with his long time research partner Amos Tversky – go straight to chapter 26 ‘Prospect Theory’. It’s a fascinating excursion into clear thinking all on its own. Prospect theory is about gambling, risk-taking and expected returns. It’s a body of theory with considerable practical relevance to the king-sized mess both welfare economics and financial markets got themselves into by the late 2000s.

Kahneman re-examined the fundamentals of utility theory, articulated by Daniel Bernoulli, almost three hundred years ago. He did this long before the past decade or two’s extravagant follies came close to wrecking economies from California to Greece. Utility theory lies at the foundation of modern economics and there is a rather urgent need right now to understand what has gone so awfully wrong in so many economies. Falling back on Marxism or some kind of self-satisfied ideological cliché does not amount to such understanding. Kahneman confers considerable understanding. That’s why he deserved his Nobel Prize.

Thinking, fast and slow has five parts: Two Systems, Heuristics and Biases, Overconfidence, Choices and Two Selves. It also contains, as appendixes, two of the classic papers for which Kahneman won his Nobel: ‘Judgment under Uncertainty’ and ‘Choices, Values and Frames’. Part I sets cognitive science in an easy to understand frame of reference which acts both as a disciplined corrective to a good deal of pop psychology and a lucid introduction to the theoretical work in the following four parts of the book.

He suggests that we think of our brain – our “machine” for making judgments – as consisting of two basic systems; which he calls System 1 and System 2. He describes the characteristics of each and explains how their faults and standard ways of interacting result in many kinds of error, bias and illusion – universally and predictably, not in merely unusual or idiosyncratic cases. System 1 is the intuitive, unconscious, fast reaction part of the brain. It is emotional, holistic and instinctual. It is, as he expresses it, “a machine for jumping to conclusions”.

In certain circumstances and often in everyday life, its functions are reliable, rapid and even remarkable. But when it comes to matters that require complex, abstract thinking it is in deep trouble. System 2 is better equipped – if trained and switched on – to handle such matters. The problem with System 2 is that it is lazy and highly inclined to rationalize rather than critically examine the intuitive judgments of System 1.

In Parts II, III and IV of the book, drawing upon the work of many psychologists and cognitive scientists, Kahneman offers an endlessly fascinating dissection of the brain of Homo sap. The chapters include ‘The Law of Small Numbers’, ‘Anchors’, ‘The Science of Availability’, ‘Availability, Emotion and Risk’, ‘Causes Trump Statistics’, ‘Intuitions vs Formulas’, ‘Risk Policies’ and ‘Frames and Reality’. And at every point Kahneman exhibits a demeanour at once keenly curious, meticulously scientific and utterly unpretentious. The implications of what he imparts are enormous and need to be digested by our education systems (not least all business administration courses), our public policy systems and our methods for public debate.

An indication of the ways in which such insights can be applied was offered several years ago, in Richard Thaler and Cass Sunstein’s Nudge: Improving Decisions About Health, Wealth and Happiness. Originally completed in 2007, it was reissued in 2008 with a Postscript titled ‘The Financial Crisis of 2008′. They drew attention to the alarming reality that almost no economists or financial analysts had foreseen the crisis, or issued public warnings as it approached. They praised the behavioural economist Robert Shiller for having done so.

Shiller’s warning in 2005 had been that “social contagion” was creating a massive housing market bubble that would inevitably burst. Shiller’s books, Irrational Exuberance (2000) and The New Financial Order: Risk in the 21st Century (2003) are recommended reading. Thaler and Sunstein’s own observation is that sound public policy, informed by the insights of cognitive science and behavioural economics, needs to invent ways (they suggest a number) to prevent or defuse such outbreaks of social contagion, or what Charles Mackay long ago called ‘extraordinary popular delusions and the madness of crowds.’

As Michael Lewis’s peerless writing shows, a little thoughtful analysis can reap enormous dividends. If markets and capitalism are to flourish and the costs of human stupidity are to be contained in future, then many things will need to be rethought and reformed. Lewis’s latest book, Boomerang: The Meltdown Tour, a characteristic tour de force shows this from Iceland and Ireland to Greece, Germany and California. If you don’t read Kahneman this summer, you simply must read Lewis.

Kahneman, meanwhile, is hard at work trying to engineer better thinking in the marketplace, or at least to nudge the unwilling and unwitting in that direction. He is a partner in a firm called Greatest Good, committed to applying cutting-edge data analysis and the insights of behavioural economics to real business challenges. His associates are a highly impressive group of people, including Steven Levitt (of Freakonomics fame), innovative economists Gary Becker and John List, the checklist manifesto man Atul Gawande and the brilliant theoretical physicist Lisa Randall. Now that, to paraphrase Groucho Marx, is a club of which I’d like to be a member.

About the author: Dr. Paul Monk has a PhD in international relations from Australian National University. Paul worked for the Australian Department of Defence and the Defence Intelligence Organisation, where he later became head of China analysis and chairman of the inter-agency working group on China. He is a keynote speaker at After America: the Port Phillip Publishing Investment Symposium, March 14th-16th at Sydney’s Intercontinental Hotel.

Regards,

Dan Denning
Editor, The Daily Reckoning

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[By Matthew Partridge, Contributing Editor, MoneyWeek (UK)]

What’s been the main driver of the gold bull market?

Low interest rates? Fear of inflation? Currency wars?

Each of the above has certainly played a role in gold’s decade-long winning streak.

But, according to a fascinating new piece of research from US fund manager GMO, the biggest reason for gold’s rise is something that most investors still don’t fully understand.

And it suggests that gold’s bull market could have some way to run…

Gold bears often argue that the gold market is now at the mercy of demand from speculative investors, who have piled into exchange-traded funds (ETFs), chasing gold higher. The danger is that if the market turns sour, they could pull their money out en masse and send the price plunging.

But according to a study by Amit Bhartia and Matt Seto of US investment firm GMO, the majority of physical gold purchases in the past decade have not come from speculators in ETFs. Indeed, ETFs only account for a tiny fraction (around 7.5%) of the near-30,000 tons of gold purchased between 2000 and 2010.

The demand didn’t come from developed market investors or central banks either – in fact, central banks have been net sellers.

Instead, nearly 80% of the total demand for physical gold has come from retail purchases in developing markets. China and India’s combined demand alone amounts to more than that of the entire developed world.

In other words, “the main driver for gold’s dramatic rise has been the emerging markets consumer”, say Bhartia and Seto.

Why? It’s pretty straightforward. While trade liberalisation and the commodity boom enabled emerging markets to prosper, their financial systems have not kept up with the pace of modernisation. Combined with a tendency to save – rather than spend – money, this has led to a large build-up of savings. (Or, as economists call it, a “savings glut”).

Now, what can all these savers in emerging markets do with their savings?

One solution is to invest it abroad. Some argue this led to the low interest rates that drove the credit boom in the US and Europe (as money from Asia flooded into US Treasuries and the like, driving down bond yields). However, capital controls mean that investing savings abroad directly is not really an option for retail investors. And the domestic stock markets – particularly in China – are far too volatile to be trusted with your life savings.

There are of course domestic savings accounts. Unfortunately, in many countries the banking system is either corrupt or state-run. Negative real interest rates (i.e. adjusted for inflation) making saving money little better than burning it.

The final course left is to invest savings in hard assets. Property has proven popular. But with prices – in China at least – at record levels, and now starting to fall, this has become less attractive. That leaves gold.

“Combined gross savings in China and India increased from $557bn in 2000 to $3.4 trillion in 2010,” say Bhartia and Seto. In short, there was a huge rise in the amount of money available to invest, “and given the lack of good alternatives, gold was a preferred choice.”

You might assume that the tough patch that the Indian and Chinese economies have seen would therefore hit the price of gold. Not necessarily. Economic problems in these countries could in fact encourage people to double down on gold, especially if the banking systems and the property markets bear the brunt of the damage.

Indeed, there is already evidence that far from reducing demand for gold, the collapse of informal lending networks and the end of the property bubble in China have pushed investors further towards precious metals. Year-on-year sales of gold in China increased by nearly 50% in the holiday period from 22 to 28 January.

Gold sales in India also rose strongly last month. Meanwhile, there have been unconfirmed reports that its central bank will pay for its energy supplies from Iran in gold, in order to sidestep sanctions.

That raises the prospect of other potential threats to the gold price. Beijing seems to be becoming increasingly uneasy about domestic money going into gold purchases rather than low-yielding bank accounts. At the end of last year, the Chinese government closed down all but two of the myriad of domestic financial exchanges where gold was traded. Although this doesn’t directly affect individuals, it could be a first step toward restrictions on retail investors.

On the other hand, a more open financial system could also impact on emerging-market demand for gold. If capital controls are reduced and Indian and Chinese citizens had more freedom to invest abroad, their demand for gold could drop. And if emerging-market consumers start spending more and saving less in general, then this could hit demand for all savings products.

However, no significant reforms are anticipated, while capital controls are likely to get tighter – not looser – in the near future. Therefore the short-term prospects for gold are excellent.

Plus, as Bhartia and Seto point out, the importance of the emerging-market consumer means that those who argue that gold has become a hugely crowded trade among investors in the developed world are simply wrong.

“This analysis indicates that ‘conventional wisdom’ demand is far from saturated.” Both central banks and developed world portfolios have a lot of catching up to do, suggesting that “gold prices may very well experience another leg up.”

We’ve long been fans of gold, and the GMO paper does nothing to change our minds on that.

Matthew Partridge

Contributing Editor, MoneyWeek (UK)

Publisher’s Note: This article originally appeared in MoneyWeek (UK).

Sick of all the jabber about the Facebook IPO?

How can a company that makes $1 billion a year be worth $80–100 billion to the market? And who cares? You’ll have to go through a whole lot of rigmarole to invest in it even if you want to.

So rather than join the hype and speculation, we thought it might be more valuable for you if we looked back at what happened when a similar stock went public in Australia…

You know what we’re talking about…

Telstra Corporation Limited

It might seem like a stretch to compare Facebook with Telstra. But when you think about it, it’s really not…

You see, in its heyday, Telstra offered the latest in communication technology…

In fact, it gave you a way to keep in touch with your friends, your family, your business acquaintances via your home phone, mobile and email… It gave you a way to say hi, share news and photos, invite them to your birthday party, or tell them about your lousy day at work – pretty much what Facebook does.

And like Facebook, Telstra makes a fair chunk of its money selling ad space in the Yellow Pages. (Sensis, ‘Telstra’s wholly owned advertising and directories arm’ produces it). And of course it makes money selling phones, line rental and calls, too.

Do you remember what happened when Telstra first offered its shares to the public in 1997?

This chart (below) of Telstra Corp [ASX:TLS] only goes back to 1999. That’s when the second round of share buying opened to the public. The IPO was in 1997 – and shares were $3.30…

At its height in 1999, Telstra had an average price-to-earnings (P/E) ratio of 30. And cashflow of 51 cents per share.

Telstra Corporation Limited Share Price History

Source: Google Finance

As you can see in this chart, after opening at $8.41 (and treading water for 6 months) Telstra shares began a steady descent that now sees the shares trade for $3.36 each. It’s lost 59.98% of its price in 12 years.

Today, Telstra has an average P/E ratio of around 13… And cashflow of 21 cents per share. And the shares currently trade just above the IPO price of $3.30.

The problem is investors overpaid. And why did they overpay? Because of the euphoria of being the first to buy ‘the next big thing’… The fear of missing out… The promise of blue-sky projections…

And it pushed the share price up 154% on the $3.30 IPO in 1997… Only to see it come crashing down to earth once the euphoria wore off.

Will it be the same story for Facebook shareholders?

Aaron Tyrrell
Editor, Money Morning

The Aussie market has started the week on a good note today, up over 1% after the US markets had a strong finish last week.

The S&P500 index is now just 1.8% away from its highest level since 2008. The Dow Jones index is now at a 3 ½-year high.
It seems like just five minutes ago the markets were on their knees. Sentiment was rock bottom as recently as Christmas. So what’s going on?

Data out of the US has been getting steadily better, and the latest instalment on Friday included the US employment numbers. The Bureau of Labor Statistics (BLS) announced 243,000 new jobs. This was the best result for nearly a year, and continues a steadily growing trend.

The chart below shows these monthly employment numbers for the last 8 years to put it in context. I’ve marked the last few months in red to highlight them.

US employment numbers getting better

Source: forexfactory

On the back of this, the unemployment rate fell from 8.5% to 8.3%.

8.3% is a good improvement from 9.0% just three months ago. A lower US unemployment rate is a sign of improving economic conditions in the world’s biggest economy. If it continues, it will boost stock markets in the US and Australia alike.

The 8.3% figure shows it has been making good progress down from its peak of 10.2%. It is accelerating towards the 5% level that means close to full employment.

But the only problem about government statistics is … well … THEY ARE CALCULATED BY THE GOVERNMENT.

Like lampposts to a drunk, statistics are better for providing support than illumination.

At best, you have to read deep between the lines to draw anything meaningful out of them with analysis. And at worst, you might as well use them to pick your lotto numbers. Statistics can be easily sliced, diced, refried and repackaged to suit a government’s purpose.

Let Me Show You What I Mean…

Imagine, say, a certain American president was keen to serve a second term. His chances would look much better if that stubbornly high unemployment number came down a bit after spending the last 3 years above 8%. Don’t you think?

And doesn’t it seem convenient that the unemployment figure is suddenly heading down in an election year?

A quick bit of digging shows there was one main reason for the big drop in the US unemployment rate. And it had little to do with 243,000 new jobs. Rather it was the record drop in the number of people counted as ‘looking for work’.

The BLS stopped counting 1.2 million people as being in the labour force.

This is the biggest drop on record. It’s very quick and easy to improve the unemployment number when a population the size of Dallas is wiped off the list.

How can the statisticians get away with this?

It’s all in the fine print. When their benefits run out after two years, job seekers drop off the list of those considered to be in the labour force. Hey presto! The labour force gets smaller, and the percentage of those within this that are working, magically gets bigger overnight. Nice one Uncle Sam.

You get a very different picture if you include those that have dropped off in this way. The unemployment rate would be over 11%.

If you also add those that just plain gave up (after three years of rejection letters), as well as those wanting full-time work but making do with part-time jobs, the figure would be 15.1%.

But 8.3% sounds much better in an election year, so that’s what we saw in the mainstream media over the weekend.

The US lost over 8 million jobs in 2008 and 2009.

In the two years since then, just 3.2 million of these jobs have been ‘recovered’. Just another 4.8 million jobs needed then! Even if the unemployment figure kept dropping at its current rate, it would still take more than 20 months for all those people to find employment.

But even then that wouldn’t be enough. The US is a huge country with over 300 million citizens. Its population is growing by around 3 million a year, about half of whom want work. So you can add another 6 million new job seekers on the market since the start of 2008.

About 130,000 new jobs are needed each month to keep the unemployment rate steady.

So I have some trouble swallowing that 8.3% unemployment figure, which is a very slippery statistic.

It’s not all bad news.

The number of new jobs is improving. Also looking better is the number of unemployment claims. This is the number of people that have lost their job for the first time. This has been falling and is now closer to the natural rate of turnover that we saw before the crisis.

New entrants to the job market back to a manageable pace

Source: forexfactory

This lower number means there are fewer new job seekers coming into the market, giving it at least a fighting chance of recovering.
It has been a long slow road for the US job market, and there are some rays of light appearing.

Less people are losing their jobs and more jobs are being created. But the US job market needs this to continue for years for the true unemployment rate to improve.

The headline numbers might give the markets a boost in the short term, but no one should be cheering about a ‘US jobs recovery’ just yet.

Dr. Alex Cowie
Editor, Diggers & Drillers

A few days ago, it was rumoured India and Iran agreed to trade in hard assets… India will give Iran gold. In exchange, Iran will give India oil.

This is a huge trade. India imports about US$12 billion of Iranian oil each year. To give you an idea, $12 billion dollars of oil equals about 6.87 million ounces of gold!

In one transaction both countries have ignored the value of paper dollars. Instead, they’ve bartered one commodity for the other.

The thing is, the Indian-Iranian deal isn’t the first to use bullion as payment. But it may be the first on billion-dollar scale.

But one thing’s for sure. It’s further evidence that the way we value paper money is changing.

In fact, paying with bullion is happening more than you may think. It’s not just gold either. Consumers are using silver for smaller transactions…

Take the case of a US blogger. He recently revealed that two different people bought guns from him on eBay with silver coins.

Then there’s the Backwoods Home magazine in the US. If you don’t want to pay in cash, you can pay your subscription in silver coins.

Or the Oregon Service station that’ll reduce the cost of petrol to 20 cents a gallon if you pay using old coins…

At the time this photo was taken in May last year, two pre-1964 silver dimes were worth $5 based on their 90% silver content. Gas prices in America were nearing $4 a gallon at the time.

And there’s even a mini mart in Los Angeles that prefers junk silver instead of greenbacks as payment for your groceries….

(NB: Junk silver simply refers to American coins pre-1965, which have 40% to 90% silver content. See this video to find out more.)

It’s clear there’s a growing number of people and businesses who are ditching paper money for real assets.

Smart Knowledge is an investment newsletter service that firmly supports the gold standard. To the extent that they only offer memberships priced in ounces of gold….If you’re after their premium membership service, that’ll be 5.75 ounces, thank you.

And in September last year, Donald Trump accepted a $176,000 deposit for a commercial lease in one of his skyscrapers. But not in cash or a cheque. The company taking the lease (APMEX a precious metals investment firm) paid the deposit using three 32-ounce gold bullion bars.

It might look like a marketing stunt. But Trump’s not alone to wanting to do business with the shiny yellow metal.

In November 2010, the ICE Europe futures exchange started accepting gold bullion as a margin deposit for its crude oil and natural gas futures. Less than two months later, JP Morgan announced it would accept physical gold as collateral for some trades.

According to a Casey Research report from March last year…

‘The World Gold Council is gaining traction in its push to have the Basel Committee on Banking Supervision accept the precious metals as a Tier-1 asset for banks, along with government bonds and currencies.’

It’s surprising that precious metals aren’t already considered a top notch asset for a bank.

But maybe these few transactions are just a sign of things to come.

Because using real assets, like gold, as payment could continue to happen on a billion-dollar scale. And the more it occurs, the more it shows that people are losing faith in the US currency and paper money in general.

The world’s reserve currency is losing partners willing to trade in it. Iran has managed to completely avoid getting stuck with potentially worthless US dollars by snapping up a tangible asset.

Ironically, that puts Iran in the same camp as Donald Trump. Both are buying gold!

Now, this doesn’t mean we’ve returned to the gold standard… yet. But consumer and business trading in gold is a sign some people value precious metals more than cash.

As more and more merchants open up to the possibility of trading with bullion, maybe it won’t be long until gold is used as money for every day transactions… whether governments like it or not.

Shae Smith
Editor, Money Weekend

Ed Note: Gold and silver will be two of the big themes at the first ever Port Phillip Publishing investing conference. Held in Sydney next month, attendees will hear firsthand from Kris Sayce and Dr. Alex Cowie on where the markets are headed this year and which assets you should buy to profit. It’s not too late to book your seat for this exclusive event. Click here for details…

The Most Important Story This Week

Dr. Alex Cowie is the editor of our resource newsletter Diggers & Drillers. He also has to sleep somewhere at night. We all do – hence the constant debate over real estate in Australia. Last year Alex sold his property in Melbourne and parked the proceeds elsewhere. In this article, he breaks down why he is bearish on Aussie property. It’s a calculated approach we all should be considering.

Other Highlights This Week

Is Ben Bernanke Secretly Buying Gold and Silver Stocks?
By Dr. Alex Cowie

Institutional investors rely on precious metal price forecasts to work out how to value gold stocks. So, higher gold and silver price forecasts will lead to higher gold and silver stock valuations and prices. Something very interesting has already happened with analysts’ gold price forecasts recently. For the first time, they are starting to forecast gold prices to go up…

How Warren Buffett Plays the Tortoise and Not the Hare
By Greg Canavan

Investing is a marathon. Slow and steady wins the race. Trying to catch every rally and moving from one sector to the next ‘hot’ area of the market is a mug’s game. It makes you feel like you’re doing something but you’re really just chasing your tail…

How to Win Even if the Australian Stock Market Doesn’t Go Up
By Kris Sayce

In fact, we’ll argue the best time to buy risky assets is when the market is at its most risky. Mainly because the market has priced in much of the doom and gloom. And while we won’t say the market is at its most risky today, it’s pretty darn close to it. What’s more, it seems even the pros are giving up…

Your Money is Better Off in Stocks Than in the Housing Market in 2012
By Kris Sayce

If you’re an investor who’s concerned about the future, do you really want to take out a six-figure mortgage and pay tens of thousands of dollars in buying and holding costs? Or would you rather stick cash in the bank and take a few speculative punts on the stock market?

Last week, a massive liquidity injection from the European Central Bank (ECB) was the catalyst for change in market direction and sentiment.

While this has removed the immediate threat of a European credit crunch, it has not altered the underlying fundamentals. The Eurozone remains structurally flawed. I still believe that at some point you will see a breakup of the euro, led by Germany exiting the currency union.

Greece remains in an intractable debt problem. Portugal is not far behind. Without genuine debt relief (even the plan to reduce Greece’s debt ‘voluntarily’ by 50 per cent will not solve its problems) this saga will continue.

But debt relief means writedowns, which will trigger the payout of billions of euros in derivative insurance payments. The global banking system is not strong enough to handle such an event, so it will be avoided at any cost.

So don’t expect to see any meaningful reform in Europe.

Meanwhile, the market is acting as though the liquidity injection has solved the problem. Time and time again throughout this prolonged crisis the market has responded positively to central bank intervention. But time and time again the liquidity injection provided only a fleeting boost to prices.

I don’t expect things to be any different this time around.

The chart below shows the S&P500, the most important stock index in the world. Since the panic sell-off in August 2011, the S&P500 has advanced within a channel, identified by the blue lines. It momentarily broke below that channel in early October and then above it during the subsequent rebound in November.

It’s coming up against the top of the channel again. I think any break above it will be a false break and we’ll soon see a correction back down to the lower part of the channel. There is definitely strong momentum and sentiment behind global equity markets now. But given the still fragile fundamental economic backdrop, I expect reality to return soon.

S&P500 – Top of the channel and due for a pullback

The Australian All Ordinaries chart index looks a little different. The pattern of the past four months or so resembles a ‘bearish flag’ formation. In general, these formations serve to consolidate the moves of an existing trend – in this case a downtrend that began in April 2011. Once the consolidation period is over, the trend continues.

The All Ordinaries Index – A bearish pattern?

I’m not a chartist. But when you combine a weak economic outlook with fragile-looking charting action there’s good reason to remain cautious.

I still believe you’re seeing a pretty convincing bear market rally.

The bear market might feel like finding goods stocks is hard.

But keep in mind when searching for stocks, value and price are two different things.

With the market firmly focused on price, it’s easy to ignore (or not even care about) value.

As investors in businesses, it’s our job to focus on value not price. It’s very hard to do and not everyone’s cup of tea.

Put simply, when you estimate intrinsic value you’re estimating what a company’s really worth. This is different to its share price, which is only based on Mr Market’s emotional judgement – not rooted in sound knowledge of a company’s financial position or business fundamentals.

In the last few months, I’ve increasingly heard that value investing is useless in this environment. To be successful you need to trade and take a shorter-term view. That might work for some people. But it’s precisely at these times of great uncertainty that value investing can protect your wealth.

Greg Canavan
Editor, Sound Money. Sound Investments.

From the Archives…

Is There a Reason You’re Not Using the 90/10 Strategy?
2012-01-27 – Kris Sayce

In the Market or Under the Mattress?
2012-01-26 – Keith Fitz-Gerald

What if the Australian Dollar Was a Stock?
2012-01-25 – Kris Sayce

Why Tungsten and Other Strategic Metals Could Prove Good Investments
2012-01-24 – Dr. Alex Cowie

Will These Commodities Help You Claim The Best Investment Gains Of 2012?
2012-01-23 – Dr. Alex Cowie

Let’s talk Japan.

Every year some analyst comes out with a variation of the story that Japan’s economy is about to rebound.

Usually the argument goes something like this: Japanese markets are impossibly cheap and the central bank will be there to prevent a catastrophe.

Or sometimes there is another variation of the Cinderella story.

Either way, don’t hold your breath. Japan’s economy posted its first trade deficit since 1980 last year and the big trade surpluses needed to drive the Nikkei back to its glory days are over.

At best, Japan’s economy is going to see balanced trade figures or a small surplus in the years ahead. It won’t be enough.

If you’re not familiar with what a trade deficit is, here’s what you need to know: Japan imported $32 billion worth of stuff more than it exported for the first time in 31 years.

Fighting the Demographic Tide

Critics say there are mitigating factors behind the figures and they’re right.

Against the backdrop of one of the world’s fastest aging populations, one of the lowest birth rates on the planet, a renewed reliance on foreign energy, and a yen that is so expensive that Japanese corporations are offshoring production, it won’t be long before the country eventually plows through its savings.

So $32 billion is just the beginning…

In fact, we are more likely to see Godzilla walk out of Tokyo Bay than we are to witness a return to Japan’s halcyon days.

Worse, I believe that within the next five years, Japan’s economy will long for the good old days when the trade deficit was merely $32 billion, instead of $100 billion, $200 billion or worse.

Not one of the things I’ve just mentioned – that the critics cite as short-term influences – are anything but continuations of much longer-term trends. Nearly all of them are being driven by Japan’s declining population.

You may not know this, but Japan’s population is projected to shrink by 30% by 2060. That means the total population will go from 128 million people today to only 87 million people in less than 50 years.

That’s hard to imagine since Japan is one of the most densely populated countries on the planet. But the effects are already visible.

In my neighborhood in Kyoto, for example, we see abandoned houses that fall in on themselves after people die and there are no longer any other family members to live there. We see schools that are shut down in the region because there are no kids to attend them.

We’re also seeing companies shuttered because there are no markets for their products, including my wife’s family kimono business, which closed after 300 years in existence.

Simply put, you just can’t grow a population or its stock markets without people.

Japan also has no immigration policy to speak of, so there is no means of replacing the “silvers,” or senior workers, who are leaving their productive years behind them.

By 2060 the number of people who are 65 or older is going to double. At the same time, the number of people in the workforce between 15 and 65 is going to shrink to less than 50% of the total population.

By 2050, there will be 75 retirees for every 100 workers. By comparison, in the United States in 2050 there will be about 32 retirees per 100 workers.

You’d think Japan could get “busy” and produce more children but even that’s problematic. The country has one of the lowest birthrates on the planet. Many young Japanese simply don’t want romance — let alone children.

In fact, many Japanese don’t even want sex.

As reported by CNBC, one AFP study reported that 36.1% of teenage boys between the ages of 16 and 19 have no interest in sex. That study in 2010 reflected results that were double the 17.5% reported only two years earlier. Girls are even worse, with more than 59% in the same age group reporting no interest.

Things are so bad according to one study I’ve seen, that at the current birth rate the last Japanese person will be born 953 years from now.

Game Over For Japan?

Critics challenge this assumption, arguing that somehow Japan’s hyper-aged will reinvigorate the economy in an orgy of retirement spending and consumption.

That depends on generous pensions and an intact financial system – neither of which Japan has at the moment.

Japan’s debt stands at 200% – 253% of GDP, depending on which studies you read, and is headed in the wrong direction. In fact, it looks like a ski jump that’s three times our own debt burden. Senior citizens I know are doing everything they can to hang onto their jobs for as long as they can.

As a result, there is literally nowhere for younger workers to go… except into low value “arubaito” or part-time work with no benefits, no promotions and very little economic value to contribute to Japan’s recovery.

My nephew, for example, struggled for years in such a job before getting training and finding work as a mechanic for Mazda.

To be fair, Japanese citizens purchase approximately 95% of Japanese debt. That’s why the country has been able to hang on and has not had its own Greek holiday.

By contrast, we borrow about 50% of our money as a nation from overseas, and we’re dangerously close to our own version of Greece’s meltdown.

But as the number of retirees rises and the number of workers falls, the Japanese government is going to have challenges maintaining this internal funding capacity.

At some point – either because there are not enough debt buyers or rates rise too high – they’ll have to turn to external creditors and interest rates that could easily be double the 1.5% the Japanese government pays lenders now.

At that point, debt payments would consume more than half of all government revenue according to The Atlantic.

And then it’s game over.

So what’s an investor to do? Well for one thing, I sure as hell wouldn’t invest in Japan on anything other than an extremely short-term basis.

Despite the fact that trade deficit numbers may ping-pong back into positive territory in the months ahead, there’s no reversing the current long-term trend.

The notion that the Nikkei is somehow undervalued is naïve if you do not take the population and its effect on debt into account.

While it is true there may be short bursts of growth, there’s no ignoring the fact that the bellwether index is trading at 8,802.51, or 77% below the high it achieved in 1990 and 12% below where it started in 1984.

With very few exceptions, money invested in Japan’s economy is going to get trapped there.

That’s why, unless you’ve got money to burn, you can say “sayonara” to Japan.

Keith Fitz-Gerald
Chief Investment Strategist, Money Morning (USA)

Publisher’s Note: This article originally appeared in Money Morning (USA).

From the Archives…

Is There a Reason You’re Not Using the 90/10 Strategy?
2012-01-27 – Kris Sayce

In the Market or Under the Mattress?
2012-01-26 – Keith Fitz-Gerald

What if the Australian Dollar Was a Stock?
2012-01-25 – Kris Sayce

Why Tungsten and Other Strategic Metals Could Prove Good Investments
2012-01-24 – Dr. Alex Cowie

Will These Commodities Help You Claim The Best Investment Gains Of 2012?
2012-01-23 – Dr. Alex Cowie

Whatever you think of Facebook (our old pal, Dan Denning says Facebook “diminishes the quality of your thought…”) there’s no arguing it’s a great example of free market entrepreneurialism.

For an eight year old company, it has come a long way.

According to the Form S-1 filed with the U.S. Securities & Exchange Commission, Facebook made a USD$1 billion profit in 2011. That’s the third year of profits in a row. It made USD$229 million in 2009 and USD$606 million in 2010.

Make a note. That’s profit. Facebook has more cash coming through the door than it has cash going out the door.

That sets Facebook apart from one of last year’s most-watched public offerings, Groupon Inc., [NASDAQ: GRPN]. In its last annual report Groupon lost USD$389 million in 2010.

And for the first nine months of last year it lost USD$214 million.

One Internet company makes a billion… another loses hundreds of millions.

But here’s the thing: just because Groupon loses money, it doesn’t make it any less entrepreneurial than Facebook.

Both guys behind the firms had an idea. They both figured they could make a bucket load of money from it. So they took a risk and got investors to back them.

The thing for investors, looking at both companies, is which is the better investment?

Should you buy Groupon while it’s still making a loss… but with potentially years of growth ahead of it? Or should you buy Facebook, which is set to trade at a premium? (Meaning that investors have built future profit growth into today’s price.)

Or maybe you should buy both.

Two Winners and One Loser

Well, let’s look at Groupon first. We’ll straight out say we wouldn’t buy it.

Simply because we don’t see it as a viable business. The company approaches businesses to convince them to offer discounts. Groupon then splits the revenue with the business customer.

For instance, if a restaurant offers a 50% discount off a $100 meal, it splits the remaining $50 with Groupon. That’s great for Groupon. But not so great for the business – effectively, discounting its product by 75% with no guarantee of repeat business.

To us, that seems a costly way to get customers. And it seems as though while Groupon and the end consumer win, the business loses.

That’s no way to build a viable business. For a company to succeed, each side (the company and consumer) needs to believe they’re getting a good deal. That’s the beauty of free market capitalism. Each side of a deal walks away thinking they’ve come out ahead.

We’re not convinced that happens with Groupon.

Compare that to Facebook, where everyone gets something of perceived value: Facebook makes money. Advertisers pay comparatively cheap ad rates to get in front of hundreds of millions of people. And consumers get to network, show off and play silly games.

Everyone’s a winner.

So, does that mean we’d buy Facebook? Let’s see…

Can Facebook Grow Profits 275%?

Even though everyone’s a winner, it doesn’t make Facebook a slam-dunk trade. As we say, investors have built profit growth into the current price.

Estimates are Facebook will list with a market capitalisation of USD$75-100 billion. That’s huge. It’s more than 100-year old technology company, Hewlett Packard [NYSE: HPQ], which has a USD$56.6 billion market cap.

And more than dot-com darling, Amazon Inc. [NASDAQ: AMZN], which has a market cap of USD$82.7 billion.

Not only that. If Facebook has a market cap of USD$75 billion, that would value it at 20-times sales, and 75-times earnings. That’s compared to Google Inc’s. [NASDAQ: GOOG] 20-times earnings.

In other words, investors figure Facebook still has plenty of growth. And maybe it has. But with a big premium priced in, investors have big expectations.

For example, let’s assume over time Facebook’s value will move closer to Google’s of 20-times earnings. In order to justify a market cap of USD$75 billion, Facebook will need to grow profits to USD$3.75 billion.

That’s a 275% increase on today’s profits.

But that doesn’t mean the Facebook share price would go up. As we say, the share price already reflects future growth. And if it doesn’t achieve the profit growth… oh boy, the share price of Facebook would soon take one heck of a beating.

And of course, investors won’t want the Facebook share price to stay still. Investors will want the share price to go up. For that to happen it needs profits to keep growing… USD$5 billion, USD$7 billion, even USD$10 billion or more.

In other words, it has to follow the same earnings growth as Internet giant, Google. That’ll be tough… but not impossible.

New Media Beats Old Media in Ad Growth

Online advertising is growing at more than twice the rate of non-online advertising. For instance, a report at the start of last year by MagnaGlobal projected the following ad growth rates:

Source: MagnaGlobal

As you can see, every single “new media” ad channel is outgrowing the four “old media” ad channels.

Of course, some of the “new media” is growing from a low base. Such as online video, which only received USD$2.2 billion in ad dollars in 2009 compared with USD$109.5 billion for network television.

But the point is, online ads have plenty of room for growth. You can’t say the same for print advertising. You only have to look at revenues for the big media companies such as Southern Cross Media Group [ASX: SXL] to see how sales and profits have stagnated for the past five years.

So, yes, Facebook does “diminish the quality of thought”. And it is a vacuous, inane and shallow media. And the shares are likely to begin trading for an obscene premium over current profits. But…

This Stock Could Gain 588%

It’s also a great company.

It’s the perfect example of how a free market gives consumers a service they didn’t know they wanted. Remember, when businesses such as Facebook (and just a year before it, MySpace) were created, there was no guarantee of success.

It took guts by the company’s owners and investors to put time and money on the line.

Today, Facebook is a success. And the share price will reflect that.

The only dilemma for potential investors is whether Facebook will follow Google’s lead and gain 588% in eight years. Or whether it will follow MySpace down the toilet (Ed note: News Corp paid USD$580 million for MySpace in 2005… and sold it for USD$35 million in 2011 for a 93.9% loss!)

As a punter, we like Facebook as a red hot gamble. You wouldn’t want to bet your retirement fund on it, because there’s little doubt to us the shares will either soar or slump.

Facebook is a high-risk punt. It isn’t a stock for investors. It’s a stock for crazy speculators.

If that sounds like you… we’d say, go ahead, buy some.

Cheers.
Kris.

P.S. Facebook isn’t the only punt I recommend investors make in 2012. At an exclusive gathering of investors next month, I’ll explain which stocks to buy this year for maximum gains. You can reserve your seat to this event by clicking here…

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Forget about lost decades. Forecasts that we’ll be turning Japanese couldn’t be further from the truth.

Here’s why.

It’s simple, really. Deflation is not in the interest of anybody in power, so it’s very unlikely to happen.

The U.S. Federal Reserve’s policy move to target inflation just re-emphasises this point.

That’s not to say deflation is a bad thing for everybody.

For savers and those living on fixed incomes, deflation would be a very good thing indeed.

Their income would gradually increase in real terms, and their savings would become steadily more valuable. Holders of Treasury bonds would also gain mightily from deflation.

However, the very people who would gain from deflation are not in power.

The People’s Bank of China can’t vote in the U.S. (yet!), Ron Paul is not president, and there is not an organised and powerful savers’ political movement. After all, this is not Germany or Japan!

Meanwhile, in the real world, the U.S. government is spending far more than it takes in, and US debt is rising to dangerous levels. This has been happening on a bipartisan basis since at least 2001.

The Tea Party may have elected a Congress committed to reducing spending, but none of the battles of 2011 actually reduced spending – they just slowed the rate of growth somewhat.

Since much of the debt is borrowed long-term at low interest rates, the best way to reduce its burden on future generations is to encourage inflation.

Savers may lose out on the deal, but to those in Washington, the idea of inflating our way out of debt is irresistible.

Of course, sometimes we can depend on an independent central bank to resist this temptation. But at present, Fed Chairman Ben Bernanke is committed to near-zero interest rates in his fight against deflation.

Now you don’t have to be a conspiracy theorist to realise that, if the power structure is committed to at least moderate inflation, inflation is what you are going to get.

In fact, it is already brewing.

Keep Your Eye on the Money Supply

One of the more reliable signs of future inflation, at least in the medium term, is monetary growth.

In the last year, the St. Louis Fed’s Money of Zero Maturity, the nearest counterpart to the old broad-money M3, has risen by 9.5%, while the slightly narrower M2 has risen by 9.8%.

As for the monetary base, which monetary theory tells us is supposed to be the most accurate inflation indicator of them all, that’s up 29.9%. What’s more, there is no sign of M2 and M3 slowing down.

This 9% to 10% increase in the money supply is compared to a current rise in nominal gross domestic product (GDP) of about 5%. (That’s including some acceleration in 2011′s fourth quarter over earlier in the year.)

Since monetary “velocity” tends to increase continually with modern payment systems, that is far more money growth than you need to currently run the economy.

So the real puzzle is not whether we will get inflation, but why we don’t have it now.

After all, interest rates have been near zero for more than three years now, and the money supply was rising faster than the economy for many years before that.

By all accounts, prices should be higher — but they are not.

Inflation Pressures Begin to Build

Part of the answer is found overseas.

The main factor suppressing inflation since the middle 1990s has been the Internet and modern telecoms. These have made it much easier to source products in low-wage countries.

So today we buy our clothes from China, whereas 20 years ago many of these same items were made in the U.S. The result has been about a 20% decline in apparel prices since their peak in 1993.

With this effect on consumer goods, and Moore’s Law making technology-based goods cheaper and better all the time, even the rise in oil prices from about $10 per barrel in 1998 to about $100 today has been easily absorbed.

So the extra money that is sloshing around the world has pushed up commodity and energy prices, but has had much less of an effect on consumer prices.

However, there are signs that the price-suppressing effect of emerging markets manufacturing is coming to an end.

Chinese wages are rising rapidly, the currency has risen against the dollar, and China’s balance of trade surplus has almost disappeared.

In fact, consumer price inflation worldwide began trending up in 2011. Now that commodity prices are rising again – as you would expect with expansionary money policy worldwide -2012 inflation pressures are beginning to build.

And now even Ben Bernanke finally weighed in last week as he tipped the scales even more decisively towards inflation.

By promising to keep interest rates at zero until the end of 2014, Bernanke has insured that interest rates almost certainly will remain below the inflation rate for the next three years.

That alone will cause inflation to rise, so we can expect the upward pressure on prices to continue.

So forget about deflation, since it will be vigorously resisted by the Obama Administration, Congress, and the Bernanke-led Fed. Inflation will keep heading higher from here.

In fact, by Election Day in November, inflation could be at troubling levels.

As for turning Japanese? …. I don’t think so.

Martin Hutchinson
Global Investing Strategist, Money Morning (USA)

Publisher’s Note: This article originally appeared in Money Morning (USA)

From the Archives…

Is There a Reason You’re Not Using the 90/10 Strategy?
2012-01-27 – Kris Sayce

In the Market or Under the Mattress?
2012-01-26 – Keith Fitz-Gerald

What if the Australian Dollar Was a Stock?
2012-01-25 – Kris Sayce

Why Tungsten and Other Strategic Metals Could Prove Good Investments
2012-01-24 – Dr. Alex Cowie

Will These Commodities Help You Claim The Best Investment Gains Of 2012?
2012-01-23 – Dr. Alex Cowie

If you read the mainstream you probably think it’s bad news for Australia if house prices keep falling.

That it’ll be bad for the banks (which it will be). And that the entire Aussie economy will grind to a halt.

But what if that doesn’t matter?

What if falling house prices is actually a good thing?

In a moment we’ll explain why bad news for the housing market could mean good news for stocks…

But first, some in the mainstream still can’t accept what’s happening.

In today’s the Age, Ian Verrender writes:

“Rather than the much-heralded assault on the Australian residential housing market, as has been predicted for the past five years by an ever-increasing host of international and domestic doomsayers, we are instead witnessing an orderly retreat.”

Arguing against a house price crash is so 2009.

Perhaps Mr. Verrender should look at the latest press release from RP Data. Especially the following chart:

Source: RP Data

Tell buyers in Brisbane, Melbourne, Hobart, Adelaide, Perth and Darwin prices haven’t crashed. Remember it wasn’t so long ago the mainstream told you Aussie house prices can’t fall.

Borrowing 101

In reality, the crash started long ago and is in full flight now. It’s wreaking havoc on those who expected to make a killing buying a house two years ago.

But now they’re learning Borrowing 101 the hard way. They’ve found out leverage is a double-edged sword. You benefit when prices rise. But you lose when prices fall. For the poor souls who bought at the peak, using a 90-95% mortgage, they’re already in negative equity.

In fact, a buyer needs prices to rise at least 10% in the first year just to break even – after factoring in buying costs and mortgage costs. So when prices fall 8.7% (as they have in Brisbane), it’s a big deal.

Because now those buyers need the price to rise at least 20% to get back to square one. And the more time passes without prices going up, the worse it gets. The knock-on effect is others will fall into negative equity too.

This is something most of the so-called property experts don’t get. They’re too busy with their fancy spreadsheets and economic models to fathom the impact of falling credit.

But failure to understand credit isn’t their biggest mistake. Their biggest mistake is to think housing drives economic progress.

It doesn’t.

Housing is the reward for economic progress.

Or that’s how it should be.

Too Many Cakes

Except the credit bubble distorted the market. Rather than working hard to achieve the reward, credit has allowed consumers to get the reward first with the promise they’ll earn it later with hard work.

Trouble is, with so much effort going into building the reward, they forget about the rest of the economy. We liken it to an athlete stuffing his face with cream cakes before the race because he’s so certain he’ll win. Only, when it comes to running the race, with a belly full of cake, the athlete is no longer in the right shape to win.

That’s what happened to the U.K and U.S. housing markets. And it happened to the Aussie housing market too.

With so many resources going into building houses and apartments… and so much bank lending going towards housing… real businesses miss out.

But now, with falling house prices, could this actually spell good news for Aussie businesses and stocks? If so, it could mean higher stock prices and bigger returns on your investments.

Think about it…

You could see a shift towards stocks if investors wake up to the idea that housing is an expensive investment and that returns aren’t guaranteed.

If you’re an investor who’s concerned about the future, do you really want to take out a six-figure mortgage and pay tens of thousands of dollars in buying and holding costs? Or would you rather stick cash in the bank and take a few speculative punts on the stock market?

Stocks to Do Better Than Housing This Year

And consider this: is it a coincidence that U.S. home prices keep falling even though the U.S. stock market has more than doubled since March 2009?

Of course, central bank money-printing and low interest rates have played a large part in boosting stock prices.

But why didn’t it boost house prices? Simple, because housing is expensive and investors lost faith in the ability to make a buck from it.

Now, “Australia is different”, you’re always told. Because, in Australia, the Reserve Bank of Australia (RBA) can lower interest rates to stop house prices falling, boost demand and push prices up.

So far that hasn’t happened. In fact, the latest home sales numbers show the RBA’s last two interest rate cuts haven’t helped the Aussie housing market.

As even the housing bulls at CommSec note…

“New home sales fell by 4.9 per cent in December and was holding just shy of the 11-year lows reached in September.”

If what happened in the U.S (and U.K.) is anything to go by, there’s a good chance the same pattern will repeat here: investors will stay clear of expensive housing and buy stocks instead.

Remember, interest rates are low because central bankers want to stimulate the economy… because investors, consumers and businesses are cautious.

And as long as that continues (and it seems set to) it’s unlikely consumers will borrow large amounts of money to buy risky, illiquid and over-priced housing…

Not when you can buy dividend paying stocks that pay an income stream and growth stocks that you don’t need to borrow a fortune to buy.

Already Aussie investors are unknowingly following the lead from overseas. They’re getting tired of falling bank deposit rates and are instead looking at the risky and liquid but not over-priced shares in the stock market.

As far as 2012 goes, there’s no argument. The more house prices fall, the better it is for stocks.

Cheers.
Kris.

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The way I see it, U.S. and European energy traders will be lucky if the door doesn’t hit them in the backsides as everybody heads for the doors.

Like so many Western investors, they still have their blinders on.

They think that if demand in the U.S. and the European Union (EU) begins to slide that oil prices will fall into the toilet right along with it.

But what they don’t see is that Asian oil demand is what actually “drives” the global oil market.

This is why today’s investors need to adopt an energy investment strategy focused on what is happening on the other side of the Pacific.

Because what happens there is critical to higher prices and profits here.

Here’s why.

First, consider Asian demand.

In the fourth quarter alone, Asian demand increased by 400,000 barrels per day even as consumption in the rest of the world fell by 700,000 barrels a day, according to the International Energy Agency (IEA).

Meanwhile, Chinese demand in particular is so strong that the Red Dragon is set to import more oil than the United States within two years, according to my projections.

And don’t take my word for it. Goldman Sachs Group Inc. (NYSE: GS) thinks the U.S. will be overtaken by China this year, while the IEA believes it will happen in 2020.

I think that’s splitting hairs frankly.

What matters is that Asian oil demand growth is likely to represent a staggering 70% of the world’s total oil demand growth this year. Or more depending on which studies you believe.

As China Rises the World Shifts Toward Dubai Oil

Second, consider the effect Asia has on how oil is priced.

U.S. investors have focused on U.S. and Brent oil prices for years, and with good reason. North American markets have been the largest in terms of both consumption and growth.

Now, however, Asia’s demand growth of more than 720,000 barrels per day dwarfs our own.

By comparison, U.S. demand growth is only 310,000 barrels per day while Europe’s demand growth is positively anemic at only 260,000 barrels per day, according to the IEA.

That means Dubai’s Mercantile Exchange is rapidly becoming the new pricing standard -quickly displacing the traditional Brent.

That’s where countries like China, Japan, Indonesia, Vietnam and others in the Asian Rim increasingly price their oil for delivery.

Sadly, most investors can’t even find Dubai on a map, but they’d better learn in a hurry.

Critics note that this is because Dubai crude is of lower quality and the Libyan revolution left world markets without sweet crude.

True, but they’re missing the point – Asian demand is shifting commodity pricing from London, New York and Chicago to Dubai, and even Shanghai, where traders believe it more accurately reflects regional pricing influences.

And as China’s demand grows, prices head higher.

Oil and Emerging Markets: As Simple as Supply and Demand

Third, consider infrastructure development in the emerging markets.

China and India are both constructing new refineries estimated to have more than 1 million barrels a day of processing capacity between them.

Admittedly, bringing an additional 1 million barrels a day of production capacity on line doesn’t sound like a lot in the scheme of things, especially when we’ve become numb to trillion-dollar deficits and bailouts. But think again.

The world consumes approximately 89.5 million barrels a day yet has production capacity of only 90 million barrels a day give or take.

This means the amount of production capacity being brought on line exceeds total current global excess production. It also means that the placement of that new capacity – in China and India – is likely to have a significant impact on global pricing.

Think about it. Supply and demand determines prices. It’s one of the most basic of all economic principles.

If demand increases or there is a disruption in supply, there is upward pricing pressure. If demand falls relative to supply, prices drop.

By the same measure, if there is a limited supply and growing demand coupled with new capacity, pricing power shifts from markets where demand has dropped to markets where demand is rising.

You see this in your own neighborhood on a much smaller scale already.

If there are two service stations in town and a third one is built, customers start buying from the third station… particularly if it’s closer to where they live, has more attractive prices, better gas, or is closer to the refineries servicing it.

Initially prices will drop in response to increased competition. But, over time, as the new entrant disrupts the existing supply and demand balance, prices actually tend to rise, particularly if the three service stations now have to fight over the same limited number of tankers serving the community.

Then there is the process of demand building to consider. New capacity arguably facilitates demand growth.

I think that’s a battle that’s already begun.

Take the Chinese government for example. Beijing is likely to use its newly built refinery capacity to boost strategic reserves.

Many people believe this will be a function of China’s growing military demand, but China’s growing transport sector is far more important because it moves the goods needed by 1.3 billion people to market.

So they’ll buy as much oil as it takes to prevent a revolution…even if it means we don’t have any left to buy (except at exorbitantly high prices). This is why Chinese oil companies have been buying up oil assets anywhere they can get their hands on them.

They know it’s an issue of domestic survival rather than global domination, as the West prefers to think about their action.

At the same time, the so-called Arab Spring has interrupted the capital investments needed to maintain current oil production, shipping, and pricing levels.

This is significant because oil markets cannot function without constant capital improvement and investment, at least not at current prices.

Factor in the vulnerable oil transportation routes in the Gulf, the Malacca Straits and one can easily envision $150-$200 a barrel in risk premiums alone if things heat up…even without open hostilities.

More if the shooting starts.

Either way, it’s time for western oil investors to take the blinders off.

Keith Fitz-Gerald
Chief Investment Strategist, Money Morning (USA)

This is an edited version of an article that first appeared in Money Morning (USA)

From the Archives…

Is There a Reason You’re Not Using the 90/10 Strategy?
2012-01-27 – Kris Sayce

In the Market or Under the Mattress?
2012-01-26 – Keith Fitz-Gerald

What if the Australian Dollar Was a Stock?
2012-01-25 – Kris Sayce

Why Tungsten and Other Strategic Metals Could Prove Good Investments
2012-01-24 – Dr. Alex Cowie

Will These Commodities Help You Claim The Best Investment Gains Of 2012?
2012-01-23 – Dr. Alex Cowie

China and India are now seen as distinct investment areas, rather than just another part of an emerging-market whole. But this isn’t true of Southeast Asia and the ASEAN bloc.

Few investors think about this region in its own right. And there are very few dedicated Southeast Asia funds. Even some that are supposed to focus on the region have drifted into investing in Korea, Taiwan and China.

Yet, this is a major part of the emerging world and it deserves far more attention than it gets.

From an investment viewpoint, the best way to assess Southeast Asia is to look at the ASEAN countries collectively, rather than as individual economies. The ten-member ASEAN bloc (Association of South East Asian Nations) consists of founders Indonesia, Malaysia, Philippines, Singapore and Thailand, as well as later entrants Brunei, Vietnam, Laos, Myanmar and Cambodia.

And there are several reasons why the region is well worth a look. First, ASEAN is slowly morphing from a talking shop, into what could be a meaningful economic bloc.

ASEAN has been around for a long time – the first five members joined in 1967. For much of that time it was largely meaningless, with little real cooperation between most of these members. But events of the last decade – such as the global financial crisis and the growing clout of China and India – have made Southeast Asia governments aware that they could benefit a great deal from pulling together.

ASEAN has a Bright Future

So ASEAN is now working towards the ASEAN Economic Community (AEC). This is a EU-style project to free-up movement of goods, capital and labour across the region. Whether some of the loftier goals for the AEC will be achieved isn’t clear. But when it comes into force in 2015, there should be very large cuts in tariffs and other barriers to trade and cooperation.

Second, a unified ASEAN is a significant marketplace by any standards. It has a population of almost 600 million, with better demographics than China, Europe or the US. Most people within ASEAN remain relatively poor, but most countries have an expanding middle class. If development continues successfully, it promises strong consumption growth for many years to come.

The third positive, is that there are few financial barriers to consumption and investment growth in the future. ASEAN learned a hard lesson from the 1997 Asian crisis and today local finances are in pretty good shape. Debt levels generally remain low for governments, households and corporates, while ASEAN banks are mostly well capitalised with good balance sheets. While most of the world must deleverage, ASEAN is on the right side of the credit cycle.

Fourth, ASEAN is diverse. It spans the entire range from wealthy, developed Singapore to poor, authoritarian Burma. This means it offers a wide range of investment opportunities. It’s well provided with natural resources, without suffering the ‘resource curse’ where unbalanced economies become too dependent on oil or mining. Even being often overlooked by investors can be an advantage, since there are plenty of under-researched companies where an active investor can find value.

ASEAN Still Has Risk

In case this sounds too Panglossian, ASEAN is obviously not immune to troubles in the rest of the world. It’s geared to export demand from the US, Europe and China, so recessions or slowdowns in these will definitely be noticed in Southeast Asia.

What’s more, financial ties in the form of European bank lending to the region means it will feel the impact of a European banking crisis. It’s worth noting though, that ASEAN is probably better placed than most of the emerging world, as most European lending to Asia is trade finance where the gap can more easily be filled by loans from governments and multilateral institutions such as the Asian Development Bank.

But I believe that ASEAN deserves more attention than it’s yet getting – and that there are some very attractive long-term opportunities here.

Cris Sholto Heaton
Contributing Editor, Money Morning (UK)

Publisher’s Note: This is an edited version of an article originally published in MoneyWeek (UK).

From the Archives…

Is There a Reason You’re Not Using the 90/10 Strategy?
2012-01-27 – Kris Sayce

In the Market or Under the Mattress?
2012-01-26 – Keith Fitz-Gerald

What if the Australian Dollar Was a Stock?
2012-01-25 – Kris Sayce

Why Tungsten and Other Strategic Metals Could Prove Good Investments
2012-01-24 – Dr. Alex Cowie

Will These Commodities Help You Claim The Best Investment Gains Of 2012?
2012-01-23 – Dr. Alex Cowie

Calm.

There’s no other word to describe it.

Since the beginning of January the Australian stock market has gained about 5%. It has done so in a calm and unexciting way. (OK, there are two words to describe it.)

That doesn’t mean it has gone up in a straight line, because it hasn’t. But so far, the stock market has lacked the crazy market volatility we saw for most of last year.

If you’ve forgotten already, perhaps this chart will remind you:

Source: Google Finance

So, does this mean it’s safe to pile back into the market?

After all, there are still a bunch of reasons why you wouldn’t buy into the Australian stock market: European debt problems, U.S. debt and economic growth worries, a slowdown in China, falling Aussie company profits.
But that doesn’t mean you should avoid it altogether…

Have the Pros Given Up?

In fact, we’ll argue the best time to buy risky assets is when the stock market is at its most risky. Mainly because the stock market has priced in much of the doom and gloom.

And while we won’t say the Australian stock market is at its most risky today, it’s pretty darn close to it. What’s more, it seems even the pros are giving up. We’re starting to see more stories such as this in today’s Australian Financial Review:

“The majority of superannuation funds have failed to meet their return targets over the past five, seven and 10 years…

“Some experts argue that super funds, which typically expect to return between 3 per cent and 4 per cent above the rate of inflation annually over the long term, should be lowering their return objectives to reflect the dismal outlook for economic growth.”

And even the Future Fund is making a big deal of having low exposure to the stock market. According to its latest quarterly report, the Future Fund has 31.6% in stocks. The rest is in cash, bonds and other investments.

Future Fund chairman David Murray says, “Super funds are over-allocated to Australian equities. There is not a lot wrong with having extra cash.”

So while we agree that most investment managers have too much of their clients’ funds in shares, we don’t believe investors and investment managers should lower their return objectives.

To our mind it’s admitting defeat. It’s like a train operator changing the timetable to reflect the late running of trains rather than trying to improve the service so the trains run on time.

The biggest mistake an investor can make is to give up.

You Need to Make the Time to Invest

Now, it doesn’t mean you have to hit the investing ball for six every year. What you have to do is actively manage your asset allocation.

That means putting money into safe assets and protecting your capital. But it also means putting part of your money into unsafe assets… investments that can move wildly up and down.

The question is, how much to allocate to these assets?

Here’s what you need to know: the more time you can devote to actively managing your investments, the less you need to put into risky assets. That sounds counterintuitive we know.

It means if you’re an investor who can stay home all day trading the stock market, you may only need to risk 5% of your portfolio on risky trades. Simply because you can quickly cut losses or lock in gains.

If you can spend some time – but not all day – on your share portfolio, then small-cap stocks are a good option. You could invest 5-10% of your portfolio to get leverage to a rising market. But you limit your downside if the stock market falls… because you’ve only allocated a small amount of your cash to small-cap stocks.

Whereas if you can’t devote much time to your investments you need to risk more. So you can potentially benefit from longer-term investment cycles. But the trouble with that strategy – as you’ve seen since 2007 – is it can take a long time for the cycle to run its course.

It’s nearly five years since the stock market topped out in 2007 and the market is still down about 40% from the peak.

How much longer will you have to wait for the stock market to breakeven with 2007? And then how much longer before you can gain back the returns you’ve missed out on?

Our guess is it could take at least five years to get back to 2007 levels. And 10 years is a long time and a lot of effort to make a 0% annualised return.

Understand the Big Picture Then Pick the Stocks

Bottom line: it’s not too late to try and make up for missed opportunities and negative returns over the past five years.

But the longer you wait the harder it is to make up lost ground.

That said, asset allocation is only part of the story. It’s also important to understand the broader market and economy (no-one said investing was easy!). Because if you understand the big picture it will help with your asset allocation.

Getting this right is the basis for our presentation at the After America investment conference in Sydney next month.

During the presentation we’ll follow up on some of the general themes (including asset allocation and portfolio management) we’ve addressed in Money Morning, plus we’ll provide specific investment advice on where you should put your money.

As we say, it’s not too late to make changes to your investment strategy… but the clock sure is ticking.

Cheers.
Kris.

Publisher’s note: If you enjoy reading Kris’s essays in Money Morning, you’ll love hearing him talking about the challenges facing Aussie investors in person. This March, Kris will be speaking at the first ever Port Phillip Publishing investment symposium in Sydney. Come along. Meet Kris. Ask him tons of questions. Marvel at how tall he is. For more information on our not-to-be-missed March conference, go HERE

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The outlook for China matters enormously to markets and the world economy.

So it’s a shame that the argument over whether or not it will have a ‘soft landing’ is framed so poorly.

What most pundits seem to mean by a soft landing is nothing of the kind. It doesn’t even qualify as a landing.

And they seem to be ignoring the risks for what is probably the most important sector in the world right now – Chinese real estate…

Chinese Real Estate Investment is Slowing Very Fast

When analysts talk about a soft landing in China, they mean a scenario in which growth gently slows to around 8%. This is widely assumed to be the minimum growth figure the country needs to maintain a solid job market and generally keep its citizens happy.

This scenario seems unlikely to me, to say the least. Especially when you look at what’s going on in the Chinese property market.

Real estate investment grew around 28% year-on-year in 2011. But it has been decelerating sharply. The year-on-year pace was 25% in October, 20% in November and 12% in December.

Chinse property accounts for around 13% of China’s economy directly and impacts on as much as 25% of GDP through related sectors. So a major slowdown here would inevitably be a serious drag on the economy.

In fact, it’s not much of an exaggeration to view Chinese real estate as the single most important sector in the world right now.

Chinese export manufacturing is facing slower demand from Europe and the rest of the world. The government seems unlikely – for now – to embark on the kind of aggressive stimulus it followed in 2008-2009. And consumer spending is obviously not going to fill the gap.

So why does this matter? Because most people seem to expect Chinese real estate investment growth of around 12-14% in 2012. That’s about half the 2011 pace, and would give you 8% overall GDP growth.

However, real estate is very cyclical. When it stops growing fast, it tends not to plateau, but to contract. And if real estate investment shrinks even a little bit, GDP growth is likely to be closer to 6%.

That might still seem pretty good. It’s certainly not a hard landing by any reasonable definition. But in an economy that has been growing as fast as China, that sort of shift in pace would be very noticeable.

Any drop may not show up fully in the headline GDP figures, which are measured year-on-year. But these tend not to capture the full extent of a slowdown, so long as growth picks up again relatively quickly.

Quarter-on-quarter growth was an annualised 8.2% in Q4 2011 from 9.5% in Q3, according to the official figures. I wouldn’t be surprised to see that rate drop much further. The ingredients are there for a much more abrupt change in the economy than most analysts want to admit.

China Needs Slower, Better Growth

This isn’t necessarily a bad thing. If growth falls because the government is deliberately trying to restrain property investment, it shouldn’t be seen as a sign of weakness. Rather, it reflects policies that should be beneficial in the long run.

I don’t believe the Chinese property bubble is anything like as big as some argue. But there’s absolutely no doubt that property developers in China are exactly the same as everywhere else: fond of piling on the leverage and overbuilding when times are good, then going bust when the cycle turns.

Western economies let real estate get out of hand and are now paying the price. Chinese policymakers are being more proactive: they’ve been clamping down on the industry for over a year.

For most of 2011, analysts constantly expected them to loosen curbs in the near future. That hasn’t happened. There have been some minor moves towards loosening Chinese monetary policy more broadly, but little relief for real estate.

Hopefully they’ll stick to this; an economy where real estate plays a smaller part will be a healthier one. But any move towards better quality growth will clearly reduce the growth rate – and not just for the next few months.

China’s trend growth rate has probably peaked. In hindsight, the mid-2000s will probably seem exceptional. With exports to the West now unable to grow so fast, the demographic dividend of cheap labour from the countryside getting smaller, and less scope for high levels of investment in real estate, the pace is likely to slow.

Indeed, the government’s target is now for 7% annual growth in 2011-2015, below the fabled 8% that analysts continue to use as a lower bound. A target has little value in itself: growth regularly beat official goals by a large margin in the past decade.

But the change suggests a shift in policy, where runaway sectors such as real estate will not be tolerated solely in the name of higher GDP.

So if China’s growth comes in lower than expected over the next year, it shouldn’t be seen as too alarming. In fact, if the brakes come off and real estate investment is allowed to accelerate again, that would be more worrying for the long-run health of the economy.

But whether the market will see it that way round is another question.

Cris Sholto Heaton
Contributing Editor, MoneyWeek (UK)

Publisher’s Note: This article originally appeared in MoneyWeek (UK)

From the Archives…

Is There a Reason You’re Not Using the 90/10 Strategy?
2012-01-27 – Kris Sayce

In the Market or Under the Mattress?
2012-01-26 – Keith Fitz-Gerald

What if the Australian Dollar Was a Stock?
2012-01-25 – Kris Sayce

Why Tungsten and Other Strategic Metals Could Prove Good Investments
2012-01-24 – Dr. Alex Cowie

Will These Commodities Help You Claim The Best Investment Gains Of 2012?
2012-01-23 – Dr. Alex Cowie

On 12 January Britain’s largest supermarket chain, Tesco, reported weaker than expected Christmas sales. It threw in a profit downgrade for good measure. As a result, the share price fell 16 per cent. It was Tesco’s largest share price decline in over 20 years.

Amongst the panic, Warren Buffett’s investment vehicle Berkshire Hathaway increased its stake in the food retailer to more than 5 per cent. Buffett first invested in Tesco in 2006. In the five years since, the stock price is down from where Buffett first bought in.

Yet he just purchased more.

This approach is what sets Warren Buffett apart from 99.9 per cent of investors. After investing in a company for 5 years, with the stock price going nowhere, most investors would ‘throw in the towel’ and sell after a profit downgrade and 16 per cent price plunge.

It’s the emotion of it all. We’re fixated on price. If the price is not doing what we want (moving steadily higher) we get restless. Sharp price movements invite an emotional response.

This is Warren Buffett’s strength. He avoids the emotional response because he focuses on the business not the stock price. Business value (and therefore share price value) is hard to grasp. It’s subjective. And you have to believe that in the long run value will always rise to the top. You just don’t know how long the long run really is.

Investing is a marathon. Slow and steady wins the race. Trying to catch every rally and moving from one sector to the next ‘hot’ area of the market is a mug’s game. It makes you feel like you’re doing something but you’re really just chasing your tail.

Over the long term, the market will deliver returns commensurate with the business performance of the companies listed on the exchange. If you invest in companies that offer the prospect of above average long-term returns, you will beat the market – over the long term.

Warren Buffett’s performance over the decades validates this approach. He is the ultimate tortoise. But keep in mind he beats the market, first, by buying companies at a good price. And second – and perhaps more important – by overcoming the emotional constraints to successful investing.

Greg Canavan
Editor, Sound Money. Sound Investments.

Ed Note: You can learn first-hand in Sydney what Greg thinks are the biggest opportunities – and risks – facing Australian investors, retirement savers and homeowners in 2012 by attending our “After America” conference. Find out more by clicking here…

From the Archives…

Is There a Reason You’re Not Using the 90/10 Strategy?
2012-01-27 – Kris Sayce

In the Market or Under the Mattress?
2012-01-26 – Keith Fitz-Gerald

What if the Australian Dollar Was a Stock?
2012-01-25 – Kris Sayce

Why Tungsten and Other Strategic Metals Could Prove Good Investments
2012-01-24 – Dr. Alex Cowie

Will These Commodities Help You Claim The Best Investment Gains Of 2012?
2012-01-23 – Dr. Alex Cowie

Many years ago as a backpacker, the timing chain went on my knackered old Falcon XF. That was the end for ‘old Falco’.

As I stood in despair with the bonnet up, an irate local ran over to me. He was yelling ‘Put the bonnet down! You don’t want those Holden-driving buggers gloating, DO YA!?’

As a fresh-to-the-Lucky-Country pom, I thought this passion was great. These days, it seems this passionate division of opinion has migrated from Ford vs. Holden over to the Australian property debate.

With good reason. Property makes up a cornerstone of many Australian’s wealth. And Aussie property has had a bull market like no other. It started in the 1970s, decades before things got going in the United States. Over 40 years, Aussie property has gained an average of about 3% a year. Doesn’t sound like much, but it adds up quickly.

From the 1990s onwards, Australian house prices went up a few gears, and never looked back. Prices rose at an average rate of 6% a year at that time.

Is the Party Over?

Australian property prices pulled back from gravity-defying heights by at least 3.7% last year. Melbourne houses are down 9%.

Many home owners are nervous. Is this pullback the start of something bigger? Nearly every property market elsewhere in the world has spent the last few years imploding. US property prices are down by 40% in six years. Compare US prices in blue on the chart below against Australian house prices (in red)

Is the 40-year run up in Aussie property setting us up
for the crash of all crashes?

Source: whocrashedtheeconomy.com

When looked at like this, if property prices were to fall, you get a sense of just how far they could go. The 40% pullback in US prices that started in 2005 would be a picnic.

But WILL they fall?

There are wildly diverse opinions on where house prices are heading. That’s what makes a market.

Part of the reason for differing opinions is that there is more than one property market in Australia.

The resource-rich states, such as Western Australia, can be rising. While an economy with slow growth, such as Victoria, can be falling. Top tier suburbs can outperform the boondocks. Boiling the country down to just one market oversimplifies it, but it is the right place to start before scratching deeper.

Another reason for differing opinions is that some commentators have a vested interest in maintaining high prices. It’s impossible for them to be objective. It’s human nature.

For example, residential property loans makes up the vast majority of banks’ balance sheets. It’s not in their interest to put out negative research that could reduce the value of their portfolio.

Yesterday’s ANZ report suggests ‘…housing market fundamentals remain supportive’. And it pins any falls during 2012 purely on sentiment.

Don’t Underestimate Sentiment

Australia dodged a crash last time because the government juiced the market with cheap loans in the form of First Home Buyers Grants. Now this sugar-hit has faded and prices are falling again, sentiment has really turned. Buyers are just waiting, knowing that house prices are likely to fall further. As they fall, their view is vindicated so they wait some more. It becomes self-fulfilling. Sentiment can quickly send a fragile market south.

Australian property has many home-grown critics.

There is now a long and growing list of international experts expecting prices to fall.

Last month, rating agency, Moody’s, reckoned current prices were ‘not sustainable’ based on simple metrics. Metrics such as the average-price-to-average-salary ratio being close to 7, when the average in the developed world is 3.

Moody’s also pointed out that city house prices have quadrupled since 1990, and household debt has tripled. The point is that this puts home owners in a very delicate position in the event of an economic shock.

The Economist Magazine calculates that, based on the ratio of rent to price, Australian property is overvalued by 53%. A leading US real estate analyst, Jordan Wirsz, is calling for the Aussie housing market to fall by as much as 60%. He said ‘I’m bearish about world real estate but I couldn’t be more bearish about the Australian market’.

This is just part of a growing chorus of voices from overseas ‘experts’. But what do ratings agencies, magazines and analysts really know? They don’t have their money on the line.

What I put more weight on is when people start putting their money where their mouth and start making bets against property.

The world’s biggest hedge fund, Bridgewater Associates, with about $120 billion in management, expects Australian property to fall and is betting heavily against the Australian dollar this year.

Bridgewater was one of the few hedge funds to make money last year, and notched up one of the best returns in the hedge fund sector at 23%. This is on the back of consistently outperforming the market over 20 years.

No one knows for sure. But taking a calculated approach, my view is the risk of a crash outweighs the chance of making a meagre gain. I voted with my feet and sold out of property a year ago, buying gold with the proceeds. My mates thought I was nuts. But so far it has been a good trade. I’ll swap back when the time is right.

Most Australian ‘experts’ reckon Australia property won’t crash, and deny it is even in a bubble.

Alan Greenspan and Ben Bernanke said the same thing to Congress in 2005.

Right before the US housing market started a 40% fall that continues today.

Dr. Alex Cowie
Editor, Diggers & Drillers

Publisher’s note: If you enjoy reading Alex’s essays in Money Morning, we bet you’d love to meet him in person. It just so happens that he’s appearing live at the first ever Port Phillip Publishing Investment Symposium in March. It’s in Sydney. You should come. To meet Alex and hear his views on China, America and Australia – go here

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One chart we like to keep our eye on is the S&P/ASX200 Small Ordinaries Index (XSO)… Because this index provides the benchmark for Aussie small-cap investments…

When it’s trending up, it’s a sign small-cap stocks could go up too. But if it’s stuck in a rut or trending down… Well, let’s just say the promise of 1,000% gains overnight on a 1-cent ‘penny dreadful’ gets even more elusive.

After having a bit of a run in the second half of 2010, XSO spent 2011 trending down. And it now finds itself at an important resistance level.

The index is trading near a 16-month low… That means small-cap stocks could be relatively cheap.

As you can see on the far right of the graph below, the small ord’s index has had trouble breaking past 2400… It’s tried 3 times – and failed – since September 2011. And now it’s set to have a crack at it again.

Will it break through to the upside this time and send small-cap stocks off to the races? Or will small-caps spend the first half of 2012 in the sin bin?

Keep an eye on this index over the next few weeks to find out for sure.

Source: Google Finance

Aaron Tyrrell
Editor, Money Morning

From the Archives…

Is There a Reason You’re Not Using the 90/10 Strategy?
2012-01-27 – Kris Sayce

In the Market or Under the Mattress?
2012-01-26 – Keith Fitz-Gerald

What if the Australian Dollar Was a Stock?
2012-01-25 – Kris Sayce

Why Tungsten and Other Strategic Metals Could Prove Good Investments
2012-01-24 – Dr. Alex Cowie

Will These Commodities Help You Claim The Best Investment Gains Of 2012?
2012-01-23 – Dr. Alex Cowie

Equity markets have been charging ahead for a few weeks. Not just here in the U.S., either.

They’ve been rising in Europe too. Even China’s Shanghai Composite, after falling 22% last year, has been percolating higher.

Thanks to the ECB filling Europe’s punchbowl, last year’s sovereign debt hangover has been mellowed by some 100-proof “hair-of-the-dog” liquidity liquor…

And it feels good.

This party atmosphere is infectious!

After the European Central Bank (ECB) poured some $600 billion (and counting) into the party bowl and let teetering European banks ladle themselves out as much as they could stomach, the Federal Reserve signaled that it wanted to throw in some free “shots,” in the form of more quantitative easing or some other easy money contribution, to make sure Europe isn’t the only party house on the block.

And now the International Monetary Fund (IMF) – the usually stodgy party-poopers of fiscal discipline fame – are trying to get themselves invited!

They know they’re not usually welcome while any economic bacchanal is raging, so they’re asking for donations of $500 billion to $600 billion (on top of the $400 billion in commitments they’re already packing), so they can man the kegs and stills and pump in whatever juice is necessary to make the budding soiree a true world party.

It’s amazing how giddy easy money makes everyone feel.

How else could we go from fearing the next “Lehman moment” to feeling like there’s enough money and time for over-indebted countries and increasingly strung-out banks to heal themselves?

Don’t get me wrong: I love a good party. I’ll stay until the music stops, or until the punchbowl is empty. I just hope I hear the music stop before everyone realises the punchbowl’s been cracked.

There’s no reason not to be participating in this market rally. And there’s no reason not to be aware of what’s driving it.

Shah Gilani
Capital Waves Strategist, Money Morning (USA)

Publisher’s Note: This article originally appeared in Money Morning (USA)

From the Archives…

Is There a Reason You’re Not Using the 90/10 Strategy?
2012-01-27 – Kris Sayce

In the Market or Under the Mattress?
2012-01-26 – Keith Fitz-Gerald

What if the Australian Dollar Was a Stock?
2012-01-25 – Kris Sayce

Why Tungsten and Other Strategic Metals Could Prove Good Investments
2012-01-24 – Dr. Alex Cowie

Will These Commodities Help You Claim The Best Investment Gains Of 2012?
2012-01-23 – Dr. Alex Cowie