The Traffic Light Game

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–Do you want to see what happens when the Money Power (more on that below) reduces us all to jittery speculators? Take a look at the chart below and you’ll see exactly what we mean. The problem with modern monetary policy is not that it’s insufficiently transparent. The problem is that it systematically destabilises the value of money. That makes life in financial markets—and life in general—a lot less predictable.

Bernanke Speaks, Investors Shudder

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–The chart is an intra-day chart of the S&P 500. You can see that the market opened at 1286. By the time U.S. Federal Reserve Chairman Ben Bernanke started droning on about inflation and the U.S. economy in the afternoon, the S&P reached that 1296 level that Slipstream Trader Murray Dawes mentioned in his Monday YouTube update.

–What Bernanke said, and the inane way in which he said it, is important. But there is an even more important point to be made: long-term plans are hard to make when short-term changes to monetary policy have such a big effect on asset values and the price of money. Bernanke thinks he’s adding transparency by talking more. Instead, he’s fuelling volatility and speculation.

–When you live in a world where the price of money is subject to arbitrary change, it’s a little like driving in a world where the traffic lights are programmed to flash differently each day. One day, the red lights might last longer than usual (because the traffic forecaster thinks it’s going to rain). Another day, because the traffic forecaster is indecisive, the light is yellow all day long. And on days where domestic life is blissful for the traffic forecaster, it might be all green, all the time.

–If the road is going to be safe for everyone so they can get to where they’re going without killing each other, the traffic light needs to be predictable. Red means stop. Green means go. Yellow means go very fast. You’d still have accidents. But the key in a complex system with so many dynamics is that the rules are clear and unchanging for everyone. This makes it easier to plan. And it reduces the chance you’re going to miscalculate and cause a major traffic accident.

–Bernanke is a lousy traffic forecaster. But then, the whole art/science/hoodoo of a private cartel setting interest rates is a sham anyway.

–Allow us to a correct an error. On Monday we published a chart showing that the All Ordinaries and the Dow Jones Industrials have not de-coupled since early March of 2009. We then claimed both were up about 50% since then and hitting resistance. That was a mistake. The All Ords is indeed up about 50% since March of 2009. The Dow, however, is up more like 82%. When we made our chart, we failed to change the setting so that both lines were showing price performance. Our apologies. The correct chart is below.

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–The correct chart is still telling us the same thing, but more so! Despite a big rebound in commodity prices, the big Aussie index has underperformed the big American index in the reflation recovery. Although to be fair, more precise accounting would show the Dow in Aussie dollar terms. This would tell you how well you would have done buying the American index versus the Aussie index over the last three years.

–Come to think of it—other than telling us how global money flows are tracking—the comparison is only useful if you’re willing to be one of the investors that does not rely on indexes to drive the performance of your portfolio. If you are in a fund that more or less imitates the major index, then you are more or less going to get index returns.

–This is fine in a long-term bull market of record credit expansion, cheap energy, and globalisation; sort of like the one the world had in 1982–2000. It was even fine in the 2003–2007 hyper-bull market, which was definitely driven by credit excess and blew up all asset values in all countries.

–But going along with the index can work against you in a bear market. Obviously. And the more important point is that when the financial markets are dominated by the Money Power, the stocks making up the benchmark indexes tend to be companies that are highly leveraged and can only grow earnings by expanding the balance sheet through access to cheap credit.

–Yes, we’re talking about you banks, brokers, real-estate companies, and insurers. Those companies get over-represented in big indexes during a credit-driven bull market. As a result, index-tracking funds and investors, or passive investors who leave their money to lazy fund managers, end up a lot more exposed to credit-driven assets than they probably would if they stopped to think about it for a second.

–Even in a post-GFC world, financial stocks still make up the largest sectoral component of the S&P 500. This fact sheet shows that financials are 15.8% of the S&P 500. Their share of S&P 500 profits has declined too. In 2006, just before the GFC got going in earnest, the financial sector generated 45% of the S&P 500’s $83.11 earnings per share. That’s what you get in a market where leveraged speculators can generate earnings from credit growth and pass the losses on to the taxpayer.

–What about here in Australia? Well the facts show the financial and property sector accounts for 31.3% of the total market cap of the ASX/200. That’s twice the current percentage of the S&P 500. Does that mean the Aussie index is twice as dependent on the financial and property sector for earnings growth? Well, not exactly. But what does it mean?

–Well, we’ll leave aside a precise break down of index earnings and their sectoral components—although if this were a paid subscription newsletter, seeing such a breakdown would be a perfectly legitimate expectation—and focus on the essential point: returns on the average Aussie indexes are even more driven by credit growth than on the U.S. market.

–Now, this is a claim more than a fact. It’s a fact that earnings growth and the big miners—thanks to record coal and iron prices—has probably been a big contributor to overall earnings growth in Australia. For example, in 2010 iron ore alone accounted for 73% of Rio Tinto’s earnings and 40% of BHP’s earnings.

–The miners expect iron ore and coal prices to stay high and then gently glide lower over the next three years as more supply finally comes online both here in Australia and abroad. But volume growth should make it possible to maintain earnings, even if prices for coal and iron ore fall (although if they fall more than expected, the earnings story will be much grimmer).

–But for miners not exposed to energy (that means you Rio) it’s going to be very hard to grow earnings from here over the next three years. That means earnings growth for the benchmark indexes will have to come from the financial and property stocks. And that could be a problem.

–Even though it’s not salad days for the banks, they have not exactly been doing it tough. But bank insiders like ANZ’s Mike Smith, Westpac’s Gail Kelly, and even the folks at the Reserve Bank of Australia see slower growth ahead…growth in mortgage lending and total credit in the economy.

–Maybe that’s the reason figures on ASX/200 sectoral earnings are kind of hard to find on the Internet. Would those figures show earnings growth on the ASX/200 has been driven mostly by property and financial stocks? And if that’s so, and credit growth no longer expands by 20% annually, won’t earnings growth slow down a lot more than people expect?

–Of course it will! But this is tantamount to saying that index-correlated investments in Australia are headed for a big fall because credit growth cannot possibly expand at double-digit rates during a global period of deleveraging. That is probably not the kind of news you would want to get out if you were encouraging people to get back into the stock market and back into funds.

–Of course this doesn’t mean you shouldn’t invest. The earnings of some companies—we’re thinking gold and silver miners and oil and gas explorers and producers—we reckon will do well for a host of factors covered ad nauseam in this space each day. But we’d venture to say you will not capture the capital gains that come with the re-rating of those shares if you go about your business as usual. Why?

–Business as usual for most investors is to own a broad basket of stocks (diversified, you are told). But the facts seem to show that the broadest baskets of Australian stocks—at least in terms of their market cap weighting and their contribution to earnings—are not broad at all. They’re highly dependent on credit expansion.

–And in case you hadn’t noticed, credit is expanding a lot less fast than it used to. It might—hold your breath—even begin to contract. S&P 200 earnings, bank profits, and probably property values, would soon follow. Our point today is that you might have far more exposure to that possibility than you’re aware of.

–The rosy-cheeked belief is that China will save Aussie investors because it’s driving commodity prices. But if Aussie index earnings are more correlated to credit growth (and its affect on property and bank stocks) not even China will save you in a credit depression.

–And by the way, if you’re an analyst out there who does have access to historical sector earnings for the ASX/200, or even forecasts and projections, don’t be shy. Drop us a note at dr@dailyreckoning.com.au

–We meant to write more about “the Money Power” and why it is in their interests to always expand credit, inflate the currency, and cause private sector bankruptcies. But that will have to wait until tomorrow. Until then…

Dan Denning
Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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8 Comments on "The Traffic Light Game"

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Rick W
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My investment advisors told me in December last year that I should be keeping my money in diversified funds rather than getting out of the share market and sitting in term deposits until the dust settles as I did. Their main argument offered was that AMP Chief Economist was forecasting All Ords to be at 5500 by end of 2011: http://www.ampcapital.com.au/K2DOCS/site_ampci/E7565862-D769-4CA4-9BC5-F85691E84A86/2010-December-31-Oliver%27s-Insights-Review-of-2010-and-outlook-for-2011.pdf?DIRECT This was counter to my own view based on the level of debt in Australia and the rising costs of inputs to the mining industry so I checked his prediction for 2008: http://www.businessspectator.com.au/bs.nsf/Article/Economic-outlook-for-2008-grounds-for-cautious-opt-A9VJY?OpenDocument His All Ords prediction of 7300… Read more »
Ross
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If we wanted more chaos we could send in the so-called traffic engineers from the NSW RTA, they’re the anti flow experts when it comes to traffic lights.

Biker
Guest

Dan: “…bank insiders like ANZ’s Mike Smith, Westpac’s Gail Kelly, and even the folks at the Reserve Bank of Australia see slower growth ahead…growth in mortgage lending and total credit in the economy…”

And, for interest rates, this means…? ;)

Lachlan
Guest

“Instead, he’s fuelling volatility and speculation.”

Ben and mates are predictably non committal now about QE, even Bill Gross saying no more QE. Hmmmm.
Oh, of course. The US government is secretly planning to lay off 95% of it’s staff now… and leave the Middle East oil for the Arabs to use up.

No, this is how they will get people to abandon long risk positions before they buy such at a discount… and then suddenly decide QE3 is necessary after all. Churn, churn, shake, shake.

Anyhow it’s no leverage, no fear and no stops here.

Place your bets gentlemen.

Stillgotshoeson
Guest
Comment by Lachlan on 10 June 2011: Anyhow it’s no leverage, no fear and no stops here. Place your bets gentlemen. Just started 2 business (joint) ventures. One. Paid cash for, the other is a leveraged position. Share portfolio has been rebalanced over the last 4 weeks. Portfolio 5% Silver Bullion 20% Shares 75% Cash Housing correction has started, Shares may bump along a little bit more before they go south too. Unemployment in Victoria has risen according to latest figures. Northern Hemisphere is still a mess, even if RBA stay, banks are probably going to have to raise rates… Read more »
Lachlan
Guest
Hi Shoes. I have no leverage on shares and my position overall is small. Therefore I am able to sit this volatility out and sleep at night. The AUD gold price is still behaving well and working its way closer to breakout day imo. A breakout on that three year pennant will be worthy of a Galway Pipe :) Silver is my star performer to date though. I’m still sticking with the asx200 not making new lows (below 09). Within the current trading range 4600 was a critical support for mine so we could be headed lower in the range… Read more »
Lachlan
Guest

Actually to be correct its the days that are cold, nights feel average.

Lachlan
Guest

Congratulations on the business move also Shoes. There are always opportunities imo.

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