Deflation Fears will Weigh on Stocks for the Next Few Weeks, Creating Opportunities

Why are stocks selling off when economists tell us declining oil prices are wonderful? Answer: full valuations, investor complacency, financial blow-ups from plunging oil prices, and fears of global deflation.

Investor Complacency

A couple of years ago you could still find some bears in the Barron’s survey of stock market strategists. No longer. They are all fairly bullish on both earnings and valuation, expecting 2015 SPX EPS of $127 (too high by about $3.00 given the drop in oil prices) and a trailing PE at year-end 2015 of 17.5x (versus 16.2x in the middle of the last cycle, i.e., Q1 2005-Q2 2007). Strategists’ average year-end 2015 target is 2200.

Another sign of complacency is investor positioning. According to the WSJ, the number of trades handled by TD Ameritrade climbed 14% in the year ending September 2014. E*Trade’s margin loans outstanding climbed 31% in the past year; at Schwab they climbed 20%.

Lower Oil Prices: Good for Consumers, Bad for Speculators

In retrospect, it is clear oil prices collapsed due to weak global growth (see below), increasing energy efficiency, and abundant new supply. But that’s all hindsight. From January 2012 to July 2014 the XLE rose 37%, and many investors expected the strength to continue. They snapped up energy-related junk bonds, which comprise 16% of the High Yield Index. Now speculators are scrambling to sell stocks and bonds in markets made less liquid by Dodd Frank.

Weak Global Growth

Much of this selling has little to do with longer-term economic prospects. That said, there is enough bad news to convince skittish investors that weak oil prices show global growth is grinding to a halt, despite obvious strength in the U.S. (see Q3 earnings, Q2 and Q3 GDP, employment, retail sales, industrial production). The gloomy global trends:

  • Europe is barely growing, due to a dysfunctional Euro-land; structural flaws in Italy and France; weak demographics; stagnant export markets; and Germany’s allergy to fiscal stimulus.
  • Japan is stagnant despite a weak Yen and super-stimulative monetary policy.
  • China is slowing sharply as its credit-fed real estate / infrastructure boom fades. Debating 7.4% versus 7.1% growth is absurd; try 5%.
  • Many emerging markets (e.g. Russia, Nigeria, Brazil, Argentina, Venezuela) are weak due to mismanagement, weak commodity prices, and a strong dollar that hikes the burden of dollar-denominated debt.

Can the U.S. “Decouple?”– Lessons from 1998

I hear commentators opine the U.S. cannot decouple from economic weakness in the Rest of the World. This is largely false, as recent trends attest. Exports will be hurt by weak demand and a strong dollar, and domestic commodity producers will struggle. That will certainly take a toll on S&P profits, which are nominal. However, domestic demand is healthy and low inflation means a lower GDP deflator—both positive for real GDP. A Republican Congress is a plus for business confidence. And it’s positive to “rebalance” the U.S. economy by slowing the oil booms in Texas and North Dakota (booms inevitably lead to inefficiencies) while other regions benefit from low energy prices.

In 1998 S&P profits rose at just a low-single pace, due to global deflation and Russian default. (Oil prices dropped 55% in the two years ending December 1998.) However, U.S. real GDP rose 4.4% in 1998 and stock prices were strong (albeit very volatile). So I think the U.S. can grow nicely next year. And don’t forget that a strong dollar will boost growth somewhat  in Europe and Japan.

Deflationary Tremors Will Weigh on U.S. Equities

Obviously the market shocks from plunging energy prices will precede the longer-term benefit. Currently we have a negative feed-back loop where investors interpret lower energy prices as bearish evidence of global deflation rather than the bullish result of improving oil field technology. With Russia raising rates to 17% to defend the Rouble the bad news is far from over; recall that a Russian default sparked the financial panic of October 1998, when Lehman Brothers had a near-death experience.

We have yet to see the full financial damage caused by weak oil for companies, banks, hedge funds, and countries. Who will take a hit if Russia or Venezuela defaults? (On a more bullish note, tougher regulation means Wall Street is far less financially over-extended than in 1997-98 when banks were competing to see who could lend the most to the wunderkinds at Long Term Capital Management, the giant hedge fund that blew up in the autumn of 1998.)

Make a List and Check It Twice

The first potentially positive signpost for equity investors will come in the second half of January when Q4 earnings results are released. Analysts will likely slash their 2015 estimates for energy companies when they hear grim guidance. On the other hand, analysts will also raise estimates for many weak-oil winners. Now is the time to make a shopping list of high quality domestic companies that stand to benefit from cheap energy via lower costs and/or stronger consumer spending. It is too early to bottom-fish among the “losers” because there is more bad news to come.

Copyright Thomas Doerflinger 2014. All Rights Reserved

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From the Greatest Generation to the Weakest (and Dumbest)

If Diane Feinstein and John McCain had been governing the U.S. during World War II, today we would be speaking German and worshipping the divine Shinto Emperor. Instead Americans look back with heartfelt gratitude at “the Greatest Generation” of men and women who defeated the Nazis and Japanese. Here are a few of the encomiums to Tom Brokaw’s influential book, The Greatest Generation:

“Mr. Brokaw has composed a sweeping tribute to Americans who saved the world: the citizen heroes and heroines who, during World War II, put themselves on the line. . . . We who followed this generation have lived in the midst of greatness.” The Washington Times

“Brokaw’s ‘greatest generation’ produced greatness in its own way and, in doing so, made the ordinary extraordinary.” The Boston Globe

“A generation of remarkable Americans—our better angels”   Ken Burns

“A moving, admittedly patriotic, testament to brave men and women who quite literally saved our skins.” Daily Press (Newport News, Va.)

“…a spell is cast upon the reader reminding us, in our cynical and fragmented age, that with enough collective energy and spirit anything can be accomplished.” Doris Kearns Goodwin

So how, exactly, did the Greatest Generation apply its universally-lauded “collective energy and spirit” to defeat the evil enemies of America and the free world—the Nazis who killed 8 million Jews and other innocents, the Japanese who in the course of conquering much of East Asia slaughtered an estimated 200,000 Chinese in the murderous Rape of Nanking?

Answer: by bombing to smithereens hundreds of thousands of Germans and Japanese, many of them civilians. No “water boarding,” no “close confinement,” no sleep depravation, diaper wearing, or snarling dogs—and no second guessing by hypocritical Congressional Committees. Just hundreds of thousands of enemy soldiers and civilians slaughtered by courageous heroes of the Greatest Generation, now lauded by the likes of The Boston Globe, Ken Burns and Doris Kearns Goodwin. Here are some of the military activities these liberal stalwarts are implicitly praising:

In February 1945 British and U.S. Air Forces dropped more than 3,900 tons of bombs on Dresden, Germany. Death toll of the Dresden Firebombing: 23,000-25,000.

During the War allied forces conducted 363 air raids on Berlin; by 1945 40% of the population had fled. After the War, the U.S. estimated that “strategic bombing” killed 305,000 Germans (the vast majority civilians) and wounded another 780,000. More than 7,000,000 German civilians were made homeless.

The U.S. Air Force dropped thousands of tons of conventional ordinance (mainly firebombs) on Japanese cities in multiple operations stretching over many months. In Operation Meetinghouse (March 1943), 279 B-29s dropped 1,665 tons of firebombs on Tokyo, causing a huge fire that destroyed 16 square miles or 7% of Tokyo. An estimated 84,000 people were killed during the raid and another 41,000 were injured. Similar attacks were directed against Nagoya (destroyed 2 square miles), Osaka (destroyed 8 square miles) and Kobe (destroyed 7 square miles and killed 8000 people). Later in the spring of 1943 there were additional raids on Nagoya (killed 3,866), Tokyo (destroyed 22 square miles), Yokohama (destroyed 7 square miles, killed 1000) and Osaka (destroyed 3.2 square miles, killed 3,960).

In 1945 the U.S. dropped Atomic bombs on Hiroshima and Nagasaki, killing at least 129,000 people.

 Just in case you were not keeping score at home, the civilian casualties enumerated above total well over 500,000. Wikipedia puts the total civilian death toll (not all inflicted by the U.S.) at 1.1 million for Germany and 0.5 million for Japan. That’s in addition to at least 4.3 million German and 2.1 million Japanese military personnel killed in World War II.

How pathetic is it that hypocritical liberals like Tom Brokaw, Doris Goodwin, and The Boston Globe praise “The Greatest Generation” and then attack the CIA heroes who kept America safe after the 9/11 Islamic attack—and did so under close oversight of Congressmen and Senators who are now attacking the CIA? It almost makes you wonder whether a future Republican-controlled Congress could bring charges against President Obama for all those civilians killed as collateral damage of drone attacks on terrorists.

(The above war figures are from Wikipedia; consider giving them a year-end gift if you value the service.)

Copyright Thomas Doerflinger 2014. All Rights Reserved.


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Dems Suffer from ODS (Obamacare Denial Syndrome)

William Galston of the Brookings Institution thinks of himself as a moderate, level-headed Democrat well-versed in the subtle intricacies of public policy. Writing in The Wall Street Journal he admonished, “Democrats, It’s Time to Move On” (past the intra-party wrangling over the unpopularity of Obamacare, recently lamented by Chuck Schumer). Galston opines:

“The American people are sending a large and urgent message to Washington. We want an economy that works for all of us, not just a favored few, and nothing we’ve heard from either party so far convinces us that you know how to get us there.”

Therefore, Galston argues, “we should spend the next two years debating answers to the questions that will define the country’s future”—the usual suspects such as how the information revolution is transforming the labor market, the soaring cost of college, infrastructure spending, promoting basic research, reducing income inequality, etc.

There’s just one problem: Arguably the biggest burden weighing on lower and middle income families is Obamacare, which a mendacious “progressive” policy elite foisted on the little people in the middle class (but not themselves). The policy flaws in this amorphous, labyrinthine legislative blob are legion, but for smaller “Main Street” businesses and their employees the two most egregious are:

  • Small businesses that do not self-insure are obliged to provide the standard one-size-fits-all Obamacare insurance policy, which is usually more expensive and less flexible than what they had before. Obama simply lied when he said, “If you like your plan you can keep your plan. If you like your doctor you can keep your doctor.”
  •  To avoid Obamacare, small businesses have a strong incentive to stay small, under 50 full-time employees, defined as workers working more than 30 hours per week. This brings some of the worst features of Italy’s sclerotic labor market to the U.S.

Bottom line: Obamacare screws millions of middle class families who lost policies they were perfectly happy with, and it screws young workers who can’t get full-time jobs and are forced to stitch together two or three part-time jobs. No wonder the economy is sluggish and the middle class is shrinking. Affluent Americans are sheltered from these effects because they mostly work for large employers who self-insure. Paul Krugman and his Princeton University colleagues love Obamacare—just not for their own families. When they go to sign up for health insurance in 2015, they will see these reassuring words on the website:

“ The Patient Protection and Affordable Care Act (PPACA) was signed into law by President Obama on March 23, 2010. Princeton University believes the active health care plan is a “grandfathered health plan” under the PPACA.” (emphasis in original)

Democrats’ Obamacare Millstone

It’s not surprising that William Galston would like to see Democrats’ “move on” from the policy catastrophe known as Obamacare, but Republicans won’t let them. By attacking Obamacare the GOP can simultaneously advance the interests of the middle class and discredit Democrats as Big Government elitists. Over the next two years a Republican Congress will try to dismantle the law piece by piece—repealing the Medical Device Tax, the Employer Mandate, the Individual Mandate, and on and on. Jeb Henserling, Chairman of the House Finance Committee, suggests that Obamacare be made voluntary, which effectively blows it up.

Democrats are in a box. As a practical matter they can’t abandon Obamacare or permit wholesale changes; the Warren Wing of the Party would never allow it, and neither would President Obama. And, since Obamacare is the son of Hillarycare and Romneycare, Hillary cannot disavow the law. Democrats are stuck with defending an unpopular, dysfunctional law that probably hurts more people than it helps while throwing a “wet blanket” on the U.S. economy. And Obamacare is just one issue alienating white middle class voters from the Democratic Party.  Another is the war on coal, the XL Pipeline, and cheap energy generally.  Still another is Obama’s embrace of the tax-cheating, race hustling Al Sharpton and his ilk.

A litmus test for candidates vying for the 2016 GOP Presidential nomination will be this: Who can most effectively attack Obamacare and put forward a smart alternative that is both politically attractive and economically sensible? (Neither John McCain nor Mitt Romney were articulate on the subject of healthcare or, for that matter, economic opportunity for the middle class.) I have no doubt that Ted Cruz, Rand Paul, Paul Ryan and Chris Christie can do this; I am not so sure about the others.

Copyright Thomas Doerflinger 2014. All Rights Reserved.



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Regulation Matters: Germany’s Green Energy Nightmare

Wall Street lavishly over-analyzes fiscal and especially monetary policy, while largely ignoring the economic impact of regulatory policy, despite its great importance for investors. Actually three disparate groups are guilty of this oversight:

  • The media tends to focus on Washington wars over the level of taxation and government spending, rather than complex regulatory issues.
  • Academic economists battle to promote their pet paradigm—Keynesianism, monetarism, supply side, behavioral economics. These macro models have their uses, but they are laughably simplistic and have little to say about regulation.
  • Wall Street economists and the traders who support them are focused on Fed policy and its implications for bond, stock, and currency markets.

It is not at all surprising that government regulation receives inadequate attention. It is a murky, mind-numbing morass of highly technical rules that cannot be reliably quantified or modeled. There are few deadlines that investors can trade against; regulation dribbles out into the economy rule by complex rule. Even seminal laws such as Obamacare and Dodd-Frank take literally years to be implemented as agencies interpret and effectuate the legislation. Regulation does not make compelling copy for the media, and regulations rarely move stock prices in a discrete and decisive way. On Wall Street any idea that can’t be expressed in one sentence or, better, a single number, tends to be ignored, rather like the fine print on a credit card application.

Germany’s Green Energy Nightmare

As an example, you could listen to hours and hours of learned discourse on Bloomberg or CNBC about the European Central Bank, the Bundesbank, quantitative easing, the level of the Euro, the budget deficits of France and Italy, banks’ balance sheets and myriad other elements of Europe’s macro gridlock, without every hearing mention of Germany’s Green Energy Nightmare. That’s a pity, because it is important in its own right and symptomatic of what ails Europe.

As a recent Financial Times article ably recounts, Chancellor Merkel (who has a PhD in physics) abandoned nuclear energy in the wake of Japan’s Fukushima nuclear disaster. Heavily subsidized “renewables” such as wind and solar were supposed to take nuclear’s place, but so far dirty coal has filled the gap. “Last year,” the FT writes, “German electricity production from lignite, a particularly polluting form of coal, reached its highest level since 1990.” So dependent on coal has Germany become that the Vice Chancellor, Sigmar Gabriel, “made a dramatic appeal to Sweden to help it out of an energy dilemma.” It seems that Sweden controls two lignite mines in Germany, mines that a new and more environmentally correct government in Sweden wants to close. Gabriel pleaded with Sweden to keep the mines open in order to help stave off an energy shortage in Germany.

This is a story of all pain and no gain. Germany is missing its carbon emission targets even as its energy costs soar and the risk of energy shortages looms. Costly kilowatts are not only squeezing the budgets of German consumers, who pay twice as much as America; they hinder hiring by undermining the competitiveness of heavy industries such as aluminum, steel and chemicals, which compete with cheap-energy venues such as Saudi Arabia and the U.S. Since 2007, 11 of 24 aluminum smelters in the EU have shut down. European smelters without cheap long-term energy contracts have production costs of $2230 per ton versus $1940 in the U.S. and $1400 in Saudi Arabia. We are not talking about a decrepit basic industry that is winding down: aerospace relies on aluminum, and autos are shifting to the white metal to cut vehicle weight and reduce emissions. So smelters support important downstream industries such as packaging, auto parts and aerospace. These industries will leave Germany if they do not have a local supply of aluminum.

Germany’s Green Energy Nightmare is hobbling Europe’s putative “locomotive” while the U.S. thrives on “tight oil” and cheap natural gas, which are far cleaner than German coal. Germany’s energy problem would not be too significant if it were an unusual “one off,” but of course it’s not. From top-to-bottom, Europe’s economy is tangled in red tape; just about the only surviving growth industry is regulation itself. But in the whacky world of macroeconomics, as practiced on Wall Street and in academia, regulation doesn’t matter much. It’s all about monetary and fiscal policy.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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Shanghai: Mr. Wang’s Bad Timing

A staple of 19th century popular literature was the lurid expose of the glamour and grit of the modern metropolis, be it London, Paris or New York.   These books invariably highlighted the cruel contrast between airy boulevards lined with elegant townhouses and, right behind them in the middle of city blocks, ramshackle warrens of courts and alleys packed with malnourished inhabitants living in dark, dank, pestilential lodgings. The word “overcrowded” does not do justice; one slum in central London had 256 residents per acre.

Happily, inequality is not so stark in today’s Shanghai, but it’s still pretty dramatic. Aura Lounge, on the 52nd floor of the Ritz Carlton in Pudong, was fully booked at 4:00 PM on a Wednesday; beautiful people in fashionable garb enjoyed tea and scones as they peered out at the nearby financial towers, elegantly enveloped in smog. BMW’s, Porsches, Mercedes and other luxury vehicles are common in Shanghai, and the buyers are locals, not rich tourists.

Quite a few of these high-living nouveaux riches are what I call “Red Robber Barons”—government bureaucrats who miraculously struck it rich while orchestrating China’s modernization over the past few decades. They are not all big shots at the pinnacle of the Beijing bureaucracy. The China Daily told the story of a “low level official in Hebei province” who stashed $19.5 million in cash in his house, along with 37 kilograms of gold and 68 property ownership certificates. Who knew that being the “general manager” of a provincial state-owned water company could be so lucrative?

A Traditional Working-class Neighborhood

I got some sense of how “the other half” lives when we visited a neighborhood that is just a five-minute drive from the oh-so-chic and over-priced Peninsula Hotel. We were on a tour chronicling the history of Jews in Shanghai; this particular neighborhood is where Jews escaping the Holocaust had to live in the 1930s and 1940s. (It was not really a “ghetto” because Jews lived alongside Chinese citizens.)

We visited the house of Mr. Wang, in a neighborhood of 19th century two-and-three story brick buildings. Turning off a major street, we entered a narrow lane crowded with small shops, mini-bikes, bicycles and residents preparing food, playing cards, etc. One gentleman was squatting on the sidewalk, skinning a couple of live chickens. On one side of the lane is a pit, recently covered with a metal shield, where residents dump their chamber pots (there is little indoor plumbing in the neighborhood). Running off this lane are even more narrow passageways, only about eight feet wide, which provide access to block upon block of low brick tenements.

Mr. Wang moved to the neighborhood in 1947 and purchased a three-story house. Bad timing: The Communists seized control of China two years later and informed Mr. Wang he would be sharing his house with several other families. The front room of the first floor is a small, dark kitchen which was once used by at least three families. It has three tiny hot plates and three dim light bulbs dangling from the ceiling. To avoid disagreements over paying the electric bill, each hot-plate / light bulb combination runs on a separate electric meter. Brilliant solution to a perennial problem! I am not completely clear about how space was allocated in this small abode, but it became more crowded over time, and some families were compelled to live their lives in rooms no larger than a walk-in closet.

Big brother, or rather the local Shanghai government, decides the fate of old-style neighborhoods such as this. Some survive; others are torn down to make way for new office buildings and high-rise apartments. (Just a couple of blocks from this neighborhood, a new business district of giant office buildings is under construction.) When neighborhoods are razed, residents are relocated to one of the thousands of high-rise apartment buildings that surround Shanghai, in which case their “journey to work” may increase from a ten-minute walk to an hour and a half riding subways and buses.

Not only do residents have no say in the fate of their neighborhood; they do not even have reliable information about what the government plans to do. Therefore, any minor investment by the government in the area—new street lights, a fresh coat of paint on the side of a building—is heralded as hopeful evidence that Big Brother has decided not to eradicate the neighborhood. This is the dark side of the administrative efficiency lauded by gullible China cheerleaders like Tom Friedman of the New York Times.

Copyright Thomas Doerflinger 2014. All Rights Reserved.


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Shanghai: Will Big Brother Smother the Service Economy?

We cleared immigration in Pudong International Airport and staggered into the arrivals hall, dazed and confused after 20 hours of travel. Two airport functionaries—call them Mr. Li and Mr. Wang—noticed us and politely asked if they could help. No thanks, we said, we’re just looking for the Marriott courtesy desk. Wrong answer: we wandered away, but in a minute Mr. Li and Mr. Wang were back, asking where we were going and could they help. They would not take “no” for an answer. In China clueless tourists, wandering aimlessly in an airport until they get their bearings, are a big no no. In Newark Airport, you could wander for days and no one would notice. Not in China. Everything is noticed.

Surveillance cameras are everywhere. I mean everywhere–even back alleys too narrow to accommodate a car. If you leave something in a cab in Shanghai, you can go to the police station and their cameras will tell you which cab you left it in.

When you catch a train to another city, the ticket does not just state the train number, time of departure, destination, etc. It also specifies which waiting room you are to sit in. And in the waiting room, passengers for each departing train are assigned a specific seating area. Plus, there is a big sign reminding travellers “your train ticket must match your personal identification documents.”

Tourists’ visas are scrutinized closely by immigration officials and hotel personnel. The visa states your date of birth, so Big Brother graciously left a birthday cake for my wife in our hotel room. Tasty but creepy.

The Communist presence is not excessive, but you get the message. Enter a bookstore, and in the front is a prominently displayed a pile of a book—a very special book, the Collected Speeches of China’s President, Xi Jinping. On the famous Bund, the riverfront avenue that once functioned as Shanghai’s Wall Street, I counted no less than 36 PRC red flags, flying proudly over the no-longer-capitalist boulevard. In the hotel the only readily available newspapers are the Shanghai Daily and its big brother, the China Daily. They both spout the Party Line, though I did find many of the stories informative and amusing.

An Information-less Service Economy?

Here’s why tight social control matters to the economy. China’s days as a low-wage manufacturing powerhouse are ending. Once upon a time GDP could grow 10% annually because young people left tiny inefficient farms to work in gleaming new factories, where their productivity (output per hour worked) was ten times higher. Those days are over because of A) the law of large numbers, B) key export markets such as Europe and Japan are stagnant, C) wages are lower in Vietnam, Thailand, Cambodia and Malaysia. Meanwhile another key growth driver, housing construction, is slowing.

Accordingly, China wants to shift to GDP growth driven by domestic consumption and service industries. But services require the free flow of information, which does not exist in China. Consider:

  •  You literally cannot find a Wall Street Journal or Financial Times on any newsstand in Shanghai. If you’re lucky you might score a variant in your hotel, such as the Asia Wall Street Journal, with stale day-old articles.
  • Many western websites are blocked in Shanghai, including ones that have nothing to do with politics, such as the United Airlines website.  (For some strange reason, the Drudge Report is exempted.)
  • You don’t have a choice of Shanghai maps; the concierge gave us one and when we asked where we could go to buy a bigger and better map he seemed perplexed. One map fits all in Shanghai.

The information shortage hinders tourism, potentially a huge service export for China. For example a big potential tourist attraction is the city of Suzhou, a medium-sized city on the Grand Canal that is famous for its traditional Chinese gardens. Four of the gardens are considered “World Class;” several others are worth visiting. Only a half hour outside Shanghai by bullet train, it should be a great day trip for tourists based in Shanghai. But right now Suzhou is difficult to visit because there is almost no tourist-friendly information such as maps, bus routes, or clear signs indicating where the gardens are located. You walk out of the train station and are pestered by shady characters in pedicabs who speak no English and all hawk the same faded garden brochure. We wandered around the town, which admittedly was rather interesting, and eventually managed to find two excellent gardens. However, it was a tedious, tiring, frustrating day. The Suzhou silk museum was closed, and we ended up killing four hours in the train station.

While China’s service sector needs more free-flowing information, it has more than enough labor. The Shanghai area has millions of under-employed people working in tiny shops with tiny inventories, or operating pedi-cabs, or just hanging out on the sidewalk playing cards. It’s common to see eight or ten men (never women) attentively clustered around a card game.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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Shanghai Brands: What’s Hot and Not

We spent ten interesting and usually enjoyable days in and around Shanghai. Here’s what I learned that is of interest to investors in U.S. stocks.

The Boeing 777’s that took us out and back were full of Chinese tourists; they were probably seeking more freedom and less pollution. There is also plenty of domestic air travel in China, even though trains are excellent. Airlines such as United and aerospace names like BA, UTX, GE etc. will remain good China plays. Tourism / business travel plays such as Marriott also seem well positioned, although I suspect there is over-capacity of luxury hotels in Shanghai.

The city has several Apple stores which were extremely busy, though probably more with lookers than buyers. Still, this is one of the best brand plays on China; “everyone” owns a smart phone in Shanghai and most probably aspire to own an Apple.

The most ubiquitous western brand on Shanghai streets is Haagen Dazs, (owned by General Mills which licenses the brand to Nestle in Canada and the U.S.).

Nike is a fairly ubiquitous brand that meets the needs and taste of Chinese consumers; New Balance is also common.

Shanghai consumers enjoy tea shops, coffee shops, and even a chocolate shop (Cocoa Colony).   Starbucks stores are ubiquitous and seemed busy though not mobbed. They face heavy competition from Costa and local brands. McDonald’s and KFC stores are common though less numerous than I expected. On the other hand, western big box stores such as Wal-Mart were not in evidence, with the exception of two IKEA stores in the suburbs.

There are several brands of Nestle bottled water—a necessity in a land where tap water is not potable. Coca-Cola is fairly common but far from a dominant brand. At a Shanghai history museum Coke had a brilliant promotion that is difficult to describe—a giant mirror set on a 45 degree angle, stretching over a horizontal space with fake window ledges, where kids could lie on their back. Parents took pictures in the mirror of their child appearing to hang from / stand on the ledge, with the Coke logo in the background. These photos will be shown again and again to relatives and friends.

Luxury Mall Glut. The official ideology of China’s Communist Party is “Socialism with Chinese Characteristics.” In Shanghai’s ritzy French Concession we discovered a gleaming “Short Hills Mall with Chinese Characteristics” or (for you parochial New Yorkers) “Madison Avenue with Chinese Characteristics.” All the big names were there—Prada, Fendi, Coach, Dolce Gabanna, etc. etc.—including a few names that, according to an expert on such matters (my wife), are not to be found in Short Hills Mall, such as de Beers and Baccarat. Unfortunately there are many similar malls in Shanghai, and while traffic is heavy on weekends the stores themselves are empty. In store after store, you see two or three eager store clerks but no customers. There are probably at least four factors at play:

  • too many stores (due to a building boom and the eagerness of firms to establish their brands in China),
  • the Internet is stealing sales from malls,
  • slowing consumer demand as housing slumps,
  • the government crackdown on “corruption” including gift-giving by officials.

Also, I suspect that as Chinese consumers become more sophisticated luxury malls are becoming passé. In the French Concession there are a few ground-level shopping compounds in old, converted buildings that feel more like London than Shanghai; the shops are indigenous rather than global brands.  Anyhow, whoever owns the big luxury malls will be taking big write-downs eventually.

Luxury cars are hot in China, though not many can afford to own them. Next to our hotel (the JW Marriott) were Mercedes and Porsche dealers; a Maserati dealership was about to open around the corner. When you get married in Shanghai, you are driven to the altar in a Bentley, BMW, Mercedes, etc. I suppose this bodes well for Tesla. By the way, due to pollution concerns you have to bid for a license to own a car; the going price is $10,000.

I saw no signs that the building boom is “grinding to a halt;” there are still plenty of half-finished skyscrapers and apartment buildings in and around Shanghai. (We took two day-trips 50-120 miles outside city.) They are starting work on a major new business district in Shanghai. However, when you see how much has already been built—the huge airport, elaborate highway system, giant train stations, bullet trains, the dozens of huge skyscrapers in the Pudong Financial District, and thousands upon thousands of apartment buildings in the city and suburbs—it is easy to believe that building activity is slowing simply due to the “law of large numbers.” Admittedly, the situation may be different further to the West.

Copyright Thomas Doerflinger 2014. All Rights Reserved


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U.S. Equities Can Grind Higher in a Weak World

Stocks are behaving pretty much as I expected:

  •  In early September I said strategists were “disturbingly bullish” and a correction would not be surprising. We did get a correction, though arguably it was not scary enough to sweep away the complacency.
  • In mid October, based on very early Q3 results, I wrote, “I believe investors will conclude in mid November that third quarter profits were fairly good and better than feared.” That appears to be correct.

Most strategists are using $126 for SPX profits next year, which seems doable. If we stay at a trailing PE of 17x, we hit 2142 by year-end 2015, up 6%, with a total return of 8%. With the world awash in liquidity, short rates near zero, and the U.S. standing out as the last bastion of capitalism, it would not be shocking if stocks do better than that. A Republican Congress would improve the regulatory backdrop, which matters more than most economists and strategists recognize because they can’t plug regulatory policy into their models.

That said, you have to be worried that Japan and Europe are using monetary easing to keep their economies afloat, when the real problem is structural flaws that are impervious to monetary policy. Both regions need a Thatcher or Reagan to revive capitalism. Meanwhile the BRICs are crumbling. (The exception is India which, having already crumbled, is trying to rebuild under Modi.) Growth in China will continue to slow as the credit crunch hits real estate, which in turn restrains consumption. No Street economist wants to be the first to forecast GDP growth under 7%, which might offend the government. Brilliant independent strategist Jonathan Anderson has no such qualms; he is quoted in the FT saying,

“I’m confident we won’t see a collapse or a financial crisis in China, but, as credit conditions tighten in the next year or so, things are going to get ugly and we will have much less growth . . . . What we will inevitably have is a big shakeout on the supply side because that’s where all the credit has gone and we may see companies start going bankrupt in droves.”

Somehow that does not make me feel better—no credit crisis in China, just companies going bankrupt in droves.

Buy-backs: Funded by Debt?

When it comes to job creation, liberals need to get their story straight. Hillary says “don’t let anybody tell you, that, you know, it’s corporations and businesses that create jobs. You know, that old theory, trickle-down economics. That has been tried. That has failed. That has failed rather spectacularly.”  Weirdly, Hillary claims that her husband’s time in office invalidated “trickle down” when the opposite is true. With Republicans in Congress restraining Federal spending and (with Bill Clinton’s approval) cutting capital gains taxes in 1997, we had a technology boom, a stock market boom, a briefly balanced Federal budget, a plunging unemployment rate, and rising real wages across the income spectrum. It was the best time for low-income workers since the mid-1960s—even though inequality increased sharply.

Anyhow, many liberal pundits writing in the NYT and FT disagree with Hillary. They are criticizing companies for buying back shares instead of investing in their business and creating jobs. And it’s not just pundits who hate buy-backs. Many stock market bears argue that one of the channels by which central banks’ “easy money” inflates stock prices is companies borrowing heavily to finance share buy-backs. This is not “real growth,” the bears argue, but unsustainable “financial engineering” that will be derailed by an eventual rise in interest rates.

DJIA Buy-backs

I decided to find out for myself whether companies really are leveraging up to fund share buy-backs. I examined the 30 Dow Industrial companies to answer, for each individual company, two questions:

  • Did the number of shares outstanding decline between 2010 and 2014?
  •  Did the debt / equity ratio increase between 2010 and 2014?

The short answers: Yes and No.

Yes, buy-backs were pervasive among these thirty “blue chips.” Between 2010 and 2014, share counts declined for every company save two (JNJ and VZ).  The median share count decline over the four years was 8.6%, implying that buy-backs boosted earnings per share by around 2.2% per year—a lot when the secular EPS growth of the S&P 500 is 6%. The companies with the biggest share count declines were HD (-19.3%), IBM (-19.8%), PFE (-21.4%), TRV (-24.1%) and V (-25.3%).

On the other hand, No, companies did not load up on debt to finance these buy-backs. The median debt / equity ratio rose only very slightly, from 38.1% to 39.7%, even though companies had ample incentive to borrow more as the economy improved and interest rates stayed low. Six companies, four of them financials, slashed their debt / equity ratios dramatically while only two (HD and IBM) increased their leverage ratio substantially. It’s true that IBM should have been doing fewer buy-backs and more investment in its business; it has fallen behind the cloud curve. But IBM is very much the exception, not the rule.

Rational Cash Use Supports Stocks

Hefty share buy-backs by the corporate giants in the DJIA is bullish, not bearish. Many of the problems of big, mature firms are self-inflicted—excessive capex, dumb expansion overseas, stupid acquisitions.   Such mistakes are likely to be fewer and smaller if companies pay a decent dividend and boost EPS growth with buy-backs.

More broadly, one reason why bearish deflationists have been far too bearish on profits is that companies have figured out how to deliver an 8-10% total return to shareholders through a judicious combination of organic growth, acquisitions, share buy-backs (which collectively generate, say, 7% EPS growth) plus a dividend yield of 2%. That’s mighty attractive when treasuries yield 2.3%.

Copyright Thomas Doerflinger 2014.  All Rights Reserved.

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Politics Uber Economics: Europe’s “War Between the States”

Today’s Wall Street Journal carries an article by Princeton economist Alan S. Blinder titled “Enough With European Austerity, Bring on the Stimulus.” The Financial Times carries similar columns every day of the week and two or three times in the weekend edition.  Come to think of it, I have written a few such articles myself.

Back to the Future

In reality, we are all missing the point. To get the proper perspective, forget about Europe for a moment and think back to the founding of the United States in the 18th and early 19th century. The nation was created by the Constitution ratified in 1788, but that document papered over the divisive issue of slavery with the “three fifths clause,” which apportioned Congressional representation based on 60% of a state’s slave population and 100% of its free population.

But as the U.S. expanded westward the slavery issue—the fundamental question of whether the U.S. would be a “free labor” nation or one that actively tolerated slavery—kept flaring up, threatening national unity. It was deftly finessed by politicians in the Missouri Compromise of 1820 (which admitted Maine as a free state and Missouri as a slave state) and the complex Compromise of 1850, but the “popular sovereignty” solution in the Kansas Nebraska Act of 1854 led to open warfare in those states. The Civil War finally settled the issue, making the U.S. “one nation, indivisible” that was free of slavery, but still extremely racist.

Nation Building in Europe

Europe is going through a similarly tortuous and torturous process of nation building that may continue for decades. Although its economic benefits have been touted over the years, the European Union was created primarily for two political reasons:

  • Avoid World War III by getting Germany and France to embrace;
  • A united Europe would be a Great Power, coequal with the U.S., China and (once upon a time) the Soviet Union.

The goal is unity and national greatness—but on whose terms? The terms of Germany (orderly, efficient, disciplined, rational, ever on guard against inflation) or France and Italy (far less so on all counts). Germany believed the strict rules requiring balanced budgets would force France and Italy to pursue economic policies consistent with German values; there would be gradual economic, political and social convergence.

But Germany’s expectations of national convergence turned out to be incorrect. Erasing profound national differences that developed over many centuries cannot be erased in a few years. And it doesn’t help that the E.U.’s structural design—one currency, one central bank, multiple fiscal policies, distinct labor markets—is simply dysfunctional, because it prevents weak national economies from having an accommodative monetary policy and weak currency.

The great divide between Europe’s North and South was revealed to me when we were vacationing in Florence a few years ago and hired a driver to take us out to Villa Gamberaia, a beautiful garden in the suburbs that overlooks the city. The driver was bitterly criticizing the corrupt politicians in the Italian legislature, who get big salaries and lots of perks for not much work. I asked the driver, “Is there a split between Italy’s hardworking businesslike North, centered on Milan, and the more easy going mores in the South, centered around Naples?” He replied that there really was not much difference between North and South—except, of course, that the South was substantially controlled by the mafia.

Oops. That’s what Germany is worried about. It does not want to let its balance sheet be used to subsidize organized crime in Italy and socialism in France.

The Germans are not dumb. They understand perfectly well the Keynesian arguments made by Alan Blinder, Paul Krugman, the FT’s Martin Wolf, etc. But they are playing for higher stakes than next year’s GDP print. When we see Germany demand that France and Italy balance their budgets and carry out “structural reforms” such as cutting taxes, allowing firms to fire workers without going to court, and getting rid of France’s 35-hour work week, we are not just witnessing an argument over economic policy. We are witnessing a political struggle about the character of Europe, similar to the standoff between America’s North and the South prior to the Civil War.

The problem for Europe is that while this political stand-off goes on the European economy stagnates, unemployment hangs around 10% and much higher for the young, and extremist political parties gather strength. Average voters won’t put up with decades of misrule by a well-compensated, ineffectual elite. I have no idea how this ends, but it won’t be pretty. Hopefully Europe can build a united nation more amicably than the United States managed to do in the nineteenth century.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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Cuomo and de Blasio Must Be Reading My Blog

A couple of days ago I suggested the Obama administration should provide some positive incentives for doctors and nurses to help out in West Africa, in order to get beyond the ideological stalemate over quarantines.  I recommended they be paid $15,000 when they completed their quarantines.

Comrades Cuomo and de Blasio have followed my advice. The New York Post reports, “The state and city will ensure that workers who travel to Ebola-afflicted areas will not lose their jobs or benefits while abroad, according to the plan. The state also will reimburse returning workers who are quarantined and their employers.” It’s nice to see that someone in government has the imagination to take some constructive actions to fight Ebola in West Africa, instead of merely engaging in arid posturing about what “the science” does or does not dictate. The Obama Administration should take note.

Copyright Thomas Doerflinger 2014.  All Rights Reserved.



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