Shanghai Still Chugging Upwards

The recent turmoil in the financial markets worldwide does not seem to have hit the Chinese. The Shanghai Composite index keeps on rising and is now at 4955, which is a gain of nearly 400% over the last two years. Has the world ever seen a more obvious stock market bubble? There was a bit of a scare in February, when everybody thought the Shanghai stock market would crash and drag the world along with it. Since then it has gone up by about 70% more! Even when global markets have plunged over the last few weeks, the Shanghai stock market has kept on chugging along upwards, after a bit of a wobble in June and July.

When is this house of cards going to come down? Nobody knows - many analysts have been calling a top since the beginning of this year, but Shanghai keeps on ignoring these warnings. But when it does come down many Chinese investors (big and small) will learn the hard reality that stock markets can actually crash. What effects this eventual popping of the Chinese stock bubble will have is hard to predict, but be sure that they will be big in some way. The Chinese do everything in a big way - the Great Wall, the Three Gorges Dams, and so on.


Stocks over Time

With the recent turbulence on the stock markets, many people are wondering if they should keep their money invested in stocks and mutual funds. The mainstream advisors all say something like "investing in stocks is always good in the long run". This has been true during the period 1982-2000. However, it has not been so for other time periods. Someone who invested $100 on the US stock market in 1929 did not get his money back until 25 years later, in 1954. If you invested in the stock market during the spring of 2000, you didn't get your money back until 7 years later, this summer of 2007. And what has inflation done to that money during those periods? Definitely not good investments I would say. Although the very long trend of the stock markets has been up from 1901 to 2007, there have been long periods where the long trend has been sideways or down. Adam Hamilton explains it well in his article Long Valuation Waves.

If you look at the Swedish stock market the long trend from 1950 to 2000 looks like it went more or less up all the time. Here is a graph of AFGX (Affärsvärldens generalindex) 1950-2006.
However, if you look at the graph adjusted for inflation, the picture is quite different.
As you can see, the Swedish stock market actually went down from 1965 to 1980, if you adjust it for inflation. Not until 1982 did it come back to the same level as 1965. This means that during this period of 17 years, stocks were not a good investment in the long run. As you can see we have also gone more or less sideways 2000-2006 too (first down and then up). I'm convinced we've now entered another 17-year period when stocks are not a good long-term investment. As Adam Hamilton says in his article, these bear market periods have historically been about 17 years long. The latest bull market of 18 years from 1982 to 2000 also fits in very well with these long cycles.

The problem now is that most people giving financial advice at banks and in the media don't remember these long waves, since most of them have started working after 1982.
They have read about these long bear markets, alright, but most of them seem to think we're living in a new age where these long waves don't exist any more. So far all expectations for a "new financial age" have been brutally hammered down, in 1929 as well as in 2000.


Harvests, Floods and Droughts

News is just out that North Korea has been hit by floods with hundreds dead and widespread damage. Tens of thousands of hectares of farmland have been destroyed. This means a bad harvest this year for a country that already needs to import grain during good years. North Korea usually does not readily admit having problems, so the fact that they ask for help probably means the situation is really bad. Read more about it in IHT.

The floods that have hit two-thirds of Bangladesh for the last three weeks are now receding, but have destroyed nearly 133,000 tonnes of rice that was about to be harvested. Read more about it in Daily India. These floods have also hit nearby Bihar in India, damaging crops on more than 1 million hectares and destroying food grain stocks. Read more about it in Daily India.

On the bright side, it can be noted that Afghanistan has doubled its production of cereals in the six years since the Taliban regime fell, according to an article from FAO.

However, global stockpiles of wheat are at 30-year lows, and the price of wheat has climbed 34 percent this year. Maize (corn) and wheat are being used as feedstocks for ethanol plants both in Europe and USA, which has driven up the price of these grains. Other food crops have also increased in price, either because they are used to produce biodiesel, e.g. canola/rapeseed, or because higher prices for corn and wheat have made farmers sow more of these and less of other crops. The prices of meat and dairy products have also risen, because the animals are fed on grain. All this will of course lead to higher food prices, which will have a number of effects.

- Emergency food relief programs for places like Bangladesh, Bihar and North Korea will cost more, leading to tight budgets for aid organisations.

- Higher food prices mean higher inflation. "Core" inflation in the USA excludes both food and energy, but this inflation measure is a scam - who can survive without food and energy? Look at the real price inflation figures instead.

- Higher food prices lead to consumers having less money left to buy other stuff. Good for mother nature, because less consumption means less resources used up. Bad for our consumer-driven economy.

The current trends of more grain converted into ethanol and harvest problems in many places in the world are likely to continue, sending food prices still higher. Add an ever-increasing world population and things are starting to look pretty grim.

Now one of the easiest things the world could do to improve the current food situation would be to stop the whole grain to ethanol business. I doubt whether the grain to ethanol industry would actually survive if it were not for government subsidies.

Additionally, it is doubtful that converting grain to ethanol actually produces any net energy gain to speak of. To produce the ethanol you need a lot of energy. Diesel to run the tractors, natural gas to produce fertilisers, more diesel for transports, etc. An important concept for all fuels is EROEI (Energy Return On Energy Invested), i.e. how much energy you need to put in to get your fuel. For crude oil EROEI is very high, about 10 to 1 for good fields. This means that you need to use the energy equivalent of one barrel of oil for every ten barrels produced. This energy is used for drilling, transports, etc. There are a number of studies of the EROEI of grain to ethanol, and they all show an EROEI close to 1. This means that you actually have to input nearly as much energy as you get out of the whole process. Some studies show an EROEI of 1.2, which means that the ethanol only contains 20% more energy than all the inputs. Is it really worth all the adverse side effects of rising food prices to get that measly extra energy? Other studies (e.g. by Patzek and Pimentel) even show that grain to ethanol has an EROEI below 1, which means you actually loose energy in the process!

In any case, even if it turns out grain ethanol has an EROEI greater than 1, we would need so much farmland to grow enough grain to feed all our cars that there simply isn't that much farmland!

So, please, could all governments stop their subsidies to the grain to ethanol business now.


And Europe?

It seems that U.S. financial institutions have managed to export some of their worst tranches of subprime loans to Europe. This can be seen from the size of the interventions by the central banks. On Thursday last week the European Central Bank had to inject €95 billion in liquidity into the markets (about $130 billion), whereas the U.S. FED only had to inject $24 billion. We still don't know the whole map of who sits on what bad credit, but it will be revealed eventually.

It is now obvious that the subprime mortgage mess is not "contained" in any way, and is definitely not contained within the country of origin, the U.S.A.

There has been a lot of news lately about U.S. housing and mortgages, but I expect all this to turn up in Europe too. Housing prices have been rising like a bubble here too, and many people are up to their ears in mortgages, and have no margins in their economy. Inspired by Robert Shiller's graph of inflation-adjusted U.S. home prices, I compiled one for home prices in Sweden. Unfortunately I could not easily find data before 1975, but here it is:
I've taken the FPI (Fastighetsprisindex småhus) divided by KPI (Consumer Price Index) and multiplied it by 1000 just to get some nice round numbers (figures from SCB). You can see that the prices have gone up and down in waves more or less like the U.S. prices from 1975 to 2000. Then, just like in the U.S. since 2000 they have risen above any previous tops, though the bubble is not as big as in the U.S. The situation is similar in most other western European countries - worse in some (notably UK and Spain), maybe better in others.

Now that lending standards have suddenly tightened up, I expect housing prices to fall in Europe too, and soon we will have our own version of the subprime mess. All major Swedish banks have said last week that their exposure to U.S. subprime mortgages is minimal, which I believe. What they do not mention is their exposure to the Swedish mortage market, which could quickly turn sour.

We definitely haven't seen the last fallout from the global tightening of credit. There are lots of pockets of bad credit all around the globe and in all kinds of markets, just waiting to pop up.


Credit Derivative Woes

My first Flute Thoughts are on what's currently happening in the financial markets, though I'll go into other subjects later. This article is a summary of stuff I've written on various forums over the last few days. I'll try to include links to pages explaining any difficult terms I'm using.

Last week was eventful in the financial markets, to say the least. Read about it in Financial Times for example.

As I see it it's just a matter of time before we get the next bad news that will sink the markets. A hedge fund or bank will come out and say that they have big problems. Maybe already tomorrow, Monday? Or Tuesday?

Though we might see a short rally up in the stock markets until the next bad news comes out.

The liquidity injections into the markets by the central banks on Thursday and Friday probably averted a number of acute liquidity squeezes and gave banks and and funds a chance to get out of their most catastrophic positions. The biggest injections were by the ECB (
€95 billion on Thursday, €61 billion on Friday) and the U.S. FED ($24 billion on Thursday, $38 billion on Friday). The ECB action was the largest one ever. Some really important institutions (e.g. major banks) must be in big trouble. To quote Erik Nielsen, the chief European economist at Goldman Sachs: "Someone must have called them and said 'we need liquidity now,' They did what a central bank is supposed to do."

These liquidity injections are extreme measures, that the central banks only take in extreme situations. These actions have a number of effects. First of all they save the banks from sudden unexpected liquidity crunches, which could very well topple them. Public faith in the banking system is vital, without it our current economic system won't work. Secondly it temporarily stabilises the markets, and might also imbue some optimism. But it also signals "danger", since it is an extreme measure, and many investors become scared and sell off their equities. In the long run, of course, it might lead to other side effects, such as more imbalances in the financial system. Anyway, these emergency actions by the central banks might mean that we won't get a fast financial crash, but rather a slow scenario.

However, I see some serious problems building up:

1. "Hedge Fund" has suddenly become synonymous to "toxic waste" and many investors will withdraw their funds from anything that smells of hedge funds. Since the hedge funds work with high leverage, often borrowing 5-10 times their capital, or even more, this means that they must sell off a lot to redeem those who wish to get out. Selloffs = markets down. Besides, certain financial instruments cannot currently be sold, since nobody wants to buy them, so they'll have to sell more liquid instruments, such as stocks or commodities (oil, metals, etc). If enough investors try to withdraw from a hedge fund, it could go bust, leading to more panic among investors. There's already a Hedge Fund Implode-o-meter to report on hedge funds that have hit the wall.
The French bank BNP Paribas stated quite clearly what the problem was when they suspended three of their hedge funds last week: "The complete evaporation of liquidity in certain market segments of the U.S. securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating,".

2. What's happening in the credit default swap (CDS) markets? These have not been mentioned much yet, with most of the focus being on the U.S. subprime mortgage markets. Mike Shedlock wrote a good article about a month ago which mentions the CDS problem - "Who's Holding the Bag". The global market for CDSs is mindbogglingly huge. As of 2006-12-31, there were $34 trillion in CDSs outstanding globally. For comparison, the total world GDP was $48 trillion in 2006. Now that the global credit markets are drying up investors and funds will start reviewing their positions on the CDS markets too. It's already doubtful whether many issuers of CDSs can live up to their promises. Besides CDSs were never very liquid instruments to begin with, and even less now. This could lead to a crisis where further liquidity injections by central banks won't be of much avail. Note that the CDS market has grown explosively over the last few years - in December 2003 there were only $3.6 trillion in outstanding CDSs.

3. So far only a few hedge funds of a few billion dollars each and one smaller bank (German IKB) have gone belly up, and also a large number of subprime lenders (see the Mortgage Lender Implode-o-meter). The markets can handle this, but what happens if a larger bank hits the wall? There will be an unprecedented domino effect, considering the fact that most major banks and insurance companies in the world are interconnected by various loans and other contracts. Besides, there are probably lots of credit default swaps connected to banks, see #2 above.

4. Another issue connected to lending is that over the last few years there have been many loans issued to companies with bad credit ratings, so called junk bonds, and to rather low interest rates, since credit spreads have been so narrow. These are the company equivalent of subprime mortgages, and not much has been written about them yet. But there will be bad news soon here too, rest assured. Many funds and banks are now probably trying to get rid of these loans and their derivatives, e.g. collateralized debt obligations (CDO) and other funny abbreviations. This before the searchlight starts illuminating this part of the credit markets.
During the last few years, the percentage of company bankrupts has been low in the world (including the USA) because it was easy and cheap to get a loan. Now when credit spreads are increasing and credit is drying up we will instead see bankrupts increasing to above their historic averages. Especially since there is a "backlog" of companies with problems that have been saved by the easy credit of the last few years. This, of course, will be a long process, since all badly run companies don't run into problems at once, but rather gradually. Then remember that many of these junk bonds are "insured" through credit default swaps (see #2 above).

Number 1 is probably already happening. Number 2 can happen any time. We might have to wait a couple of weeks or months for number 3, or even a year. Number 4 will probably evolve slowly over the next year, gradually replacing the subprime mortgage crisis as a major concern for the financial markets.