Wednesday, April 13, 2005

Dismally, as it relates to the markets. THANK YOU!

Dismally, as it relates to the markets.

David Andrew Taylor is a reflective thinker. The following is a long response to an inquiry he made. The response is long because I want to give David a lot to chew upon. I invite you to respond to his notion that "...the only correlation to a lower currency would be higher rates." I also suggest that currency plays are made by the most sophisticated of investors, often, in very risky and highly leveraged transactions. Most investors would be well served to invest in good value stocks without spending any time worrying over the value of the Dollar.

David, you pay me a great compliment by reading my articles and by asking me to add detail to my arguments about the positive correlation of interest rates and the current account deficit. I thank you for the opportunity to respond.

Positive Relationship of Interest Rates and Current Account Deficit!

I have found that there are many positive and inverse relationships that are the exact opposite of the consensus perception. The one that I have argued most often is the positive relationship between oil prices and airline stock prices. The knee jerk reaction is just like the action today in airlines and oil. The airlines are one of few groups up on a day when oil prices are down sharply. A longer term view reveals that demand for oil goes up when demand for air traffic is high. It is common sense that the price of oil goes up when there is high demand for its use. Investors mistakenly focus only on fuel as a cost to the group and therefore as a depressant to the stock price. No matter the cost of fuel, the airlines make money when load factors are high, when they charge “full” price for the tickets and when they sell many tickets. On the contrary, when the economy is very weak, airlines sell fewer tickets at lower prices and fly fewer planes; the price of oil goes down as do the prices of the airline stocks.

“I'm of the notion that the only correlation to a lower currency would be higher rates.”

It is true that a lower currency increases the price of imported goods, which is inflationary and which implies higher interest rates. However, it is important not to get the cart before the horse. The reason we are buying so much from China and other developing nations is because the goods are cheap. Buying cheap is the exact opposite of inflation.

The data prove the point. The year 1984 was the last time our current account was in balance. At the time, long rates were at 13.75%. Long rates declined for the next 21 years; bond prices increased parallel to the increasing current account deficit. The pace of the decline stalled for awhile before NAFTA was passed. After NAFTA was passed, the Current account deficit has soared and long-term interest rates have dropped. If you look only at short-term action, you miss the long-term trend. Interest rates for the past several months have been up and down but flat for the entire period and sure enough the dollar has been up and down but flat for the entire period.

One thing to keep in mind is that our currency has not declined relative to the Chinese Yuan. We continue to buy goods from China at prices that are below our costs of production! This is a very good thing for us! It is perceived as a very bad thing for us! Sooner or later, the money we spend on Chinese goods makes its way back to America. A huge part of it is invested immediately in US debt because the Chinese want to earn interest on their new-found wealth. A dollar left in a mattress in Beijing is similar to an uncashed check. It is nothing but a piece of paper that represents a claim against the US government whereas my uncashed check represents a claim against me. I don’t owe anyone a dime for holding it as long as they want. Should the bearer deposit the check, I must pay the funds but I owe without paying any interest.

One of the alarmist points of view is that the Chinese may stop investing in our treasury bonds. This is the biggest joke in town. It would be like me writing a check to you and having you threaten not to cash it! I keep a hundred bucks or more on my person almost all the time but I keep my serious money invested. It would be irrational for the Chinese to not invest their dollars. Trading the dollars for Eurodollars or other currencies does not change the fact that the dollar is an outstanding claim against the US that is drawing no interest until invested.

To review: the cycle is that we are buying goods from the Chinese for less than our cost of production. China offers low cost goods because of low cost labor and in recent years because of incredible productivity growth. China has lost more manufacturing jobs than any other country in the world in the past 10 years!!!

The situation is the same as what happen in 1700’s England. Spinning and weaving in the cottage ended quickly when factories were built. The industrial revolution in England caused massive unemployment and great creation of wealth! Long-term it created millions of high pay jobs and great wealth.

The combination of low cost Chinese labor and productivity have lowered the price of consumer goods used in America. The Chinese are using part of the dollars to buy raw materials. The world wide economy has been so strong that raw material prices have soared. None-the-less, the total price of the goods from China has remained cheap. These are labor intensive products where the total cost of the raw materials is often less than 2 to 11% of the total costs. So what if the price of cotton doubles, the price of the under-wear is cheaper now than it was before! The Chinese are making healthy margins on the manufacturing of these goods; thus, they are realizing an economic profit. The Chinese are quickly building wealth. They are reinvesting that wealth in US Treasury bonds; thus, demand for US bonds is strong and interest rates have been driven down.

Of course, the Chinese have been spending some of their new-found wealth. Sooner or later they will spend more as they will tire of investing in Treasury Bonds. This does not mean they will invest in German bunds instead. These markets are all arbitraged anyway. The key point is that the Chinese will gradually buy more and more capital goods and services from the US. They will buy GE turbines, IBM computers, Boeing airplanes and college degrees. As long as they have a surplus supply of cheap labor and relatively open markets, we will run a current account deficit with them. We will continue to reap the benefit of the lower cost labor in the same way that England benefited from cheap cotton from the states for 200 years. The profit margins US companies reap from the sale of capital goods and services are likely to be higher than the profit margins on the labor intensive industries operated by the Chinese.

One of the bigger effects of the declining dollar has been the attractiveness of real estate and other US assets to Europeans. Europeans are buying resort second homes in the US like never before. The static price of a $132,000 property has dropped to $82,000 in terms of Eurodollars in just a couple of years. One of the obvious ways to see that alarmists are barking up the wrong trees is to make the comparison of deficits in the US and in Europe. It is amazing that the alarmist see a deficit of any type as bad news for the country with the deficit and as bad news for the country with the surplus. It is illogical for the deficits to be bad news both ways.

The current facts are that Americas on average have more wealth than they have ever had. We have never spent less of our disposable income (false numbers are frequently used by alarmist to suggest that our savings rate is negative; these numbers do not properly account for retirement benefits). We are buying goods from China, India, Pakistan, Brazil, Mexico…………..and Russia for less than we can produce the goods in the US. By buying these goods cheaply, we are able to invest our capital in areas where we can make higher margins. Profits are at all time record levels.

Alarmists are frightened by the high profits; they see another bubble. Generals and stock investors always fight the last war. Sentiment is so negative that stock earnings yields are 40% higher than bond earnings yields—an unusually high margin. The fear is that bond yields will go up; therefore, the reaction is to invest conservatively. Bond yields were at 1.5% when they started going up 56 years ago and at 15% or so when they peaked in 1981. The two biggest bull markets of the century occurred when interest rates were low but climbing at a moderate pace!

Trends stay in place until they don't. Forecasters suggested that the trend in rates was about to turn for 24 of the past 24 years. I have written that a strong economic expansion could cause interest rates to increase over the intermediate term. So far, every time the fed raises short rates to “head off inflation” long-term rates go down.

The bond market appreciates that inflation is being held in check by productivity. It does not matter that much of the productivity is Chinese productivity. Those who keep screaming about inflation are focusing on a very minor percentage of the costs of goods. On average, about 70% of every product is labor. Worldwide labor rate increases are very moderate (Germany has 12% unemployment!). Almost all of the costs of goods are increasing at low rates with only selected raw materials rising quickly. The most recent data show that the rate of increase in raw material costs has declined and in many cases the nominal price has also turned down.

The bottom line is that I am bullish on the stock and real estate markets even though I am gradually selling my real estate holdings. The main reason I am selling real estate is because my wife and I are retiring from our resort rental property business. I am not a bond investor because we are obviously getting closer to the end of the long-term down trend. My family tends to buy for the long term.

If we were in the game of going after quick profits, we would be flipping resort rental properties. Baby boomers are buying second homes as fast as Europeans. The above arguments suggest that mortgage rates will stay reasonably low for many more months; thus, there will be quick money made in real estate. After paying debts and taxes, my wife and I plan to invest our real estate proceeds in stocks. Stock and bond prices are usually listed as being positively related. I will not be surprised if the ten year goes to 3.5% this year. Still, my family is buying stocks that we believe will do well over the next 4 to 20 years.

Do the Google Gulp! Buy the Big Bull Boom Bubble in the early phase. The next bust should come near the end of the decade.