Thinking Chinese

"Learn without thinking begets ignorance. Think without learning is dangerous.”
-Confucius
 
I often quote Confucius because he usually has the most impact with the least amount of words. As an amateur writer in a crack-berry country, I want to keep my word count down!
 
This weekend, The Economist focused on Confucius and China’s image in a 14 page special report on “China and America – The Odd Couple”. I have cited Harvard historian, Niall Ferguson, in recent weeks – he calls this “Chimerica.” Putting the “Chi” before the “merica”, capitalizing the “C”, is an important point to think about.
 
Some of the points of focus from The Economist were:
 
1.      “America is the world’s biggest debtor and China its biggest creditor”

2.       “China is building its first aircraft carrier”

3.      “Economic freedom is one value that Mr. Obama should not sacrifice on his first visit to China next month”


>Ok. So. What’s new about any of those points? Nothing.
 
China, or The Client as we like to call her, has $800 Billion in US Government Debt, and she doesn’t have to buy any more of it. China won’t let the Pentagon see what’s underground at her military headquarters in Beijing. And China certainly doesn’t need a lesson from Bush or Obama on what the Greenspan version of “free markets” can inspire!
 
All this said, it is important to recognize that the world is figuring all of this out. Like a Confucius’ quote, it’s pretty straightforward. China has economic leverage. China wants to build some form of military leverage with that economic leverage. And China’s want for a globally managed economic system that diversifies away from a US centric “free market is the best path to prosperity” (Kudlow/CNBC) view is becoming an important geopolitical consensus.
 
So how do you make (or not lose) money understanding this? My answer, throughout the year, has simply been this - follow the money.
 
As long as you understand what the US Dollar is doing, and can handicap what it could do next, your hard-earned capital will be fine. On Thursday, the US Dollar was down, and the SP500 closed up +1.1%. On Friday, the US Dollar was up, and the SP500 closed down -1.2%. No, this inverse correlation won’t last forever (the R-Square actually dropped this week to 0.79, using a 6 month duration); but for now, this continues to be the macro factor that matters most to your portfolio.
 
Correlations aren’t perpetual, so when does this all end? There are plenty of times in recent US history (as in the last 40 years) where the US Dollar had a positive correlation with the SP500. In fact the R-Square, using a 5-year duration, is only 0.05! Duration always matters. We know this. But do we learn without thinking?
 
“Think without learning is dangerous.” The Economist exemplifies this in another piece they did this weekend titled, “The Diminishing Dollar.” This was what I would call the popular, US centric consensus view, of why the US Dollar has been decimated:
 
“This dollar declinism is overblown. It exaggerates the scale of the slide and misunderstands its cause. Much of the recent weakness simply reverses the earlier safe-haven flight to dollars, a sign of investor optimism about riskier assets rather than their fears about America’s currency.”
 
There are so many Washington/Wall Street narrative fallacies embedded in that editorial view that I can’t waste your time going off on it this morning. Understanding that the words “declinism” and “misunderstands” are more metaphors for how incompetent financial journalism has become is probably the most important point. The Economist is a great magazine, but they should stick to what they do well.
 
The dollar isn’t “diminishing” – it’s burning. The US Dollar getting remotely close to Lehman levels is the lowest price it has ever seen – EVER is a long time. The US Dollar representing some form of “safe-haven” is a long lost hope – hope is not an investment process.
 
Is the Buck going to keep Burning, or has consensus made this a Bombed out Buck that’s ready to recover? Unfortunately, in the immediate term, only Ben Bernanke can answer that. Will he move to where marked-to-market prices have in recent months? Or will he pander to the most politicized wind that the American citizenry has ever realized as a rate of return for her Savings Account?
 
November 4th is the Game Time date. Until then, rather than depending on someone’s said “inside information” about what he is going to do with the FOMC’s “exceptional” and “extended” political language, just let the real-time price of the US Dollar tell you. The Burning Buck will lead the way.
 
So far this morning, the US Dollar is trading down pre-US stock market open. Prices of US futures are indicated higher, as a result. Now is the time to study the histories of global reserve currencies. Whether they be gold bars, pounds, or dollars, the reality is that when it comes to Americans understanding currencies, “more than half of the respondents said they had learned ‘not too much’ or ‘nothing at all’ about financial issues” (Niall Ferguson, Ascent of Money, page 13). Thinking, “without learning is dangerous.”
 
My immediate term support and resistance levels for the SP500 are now 1072 and 1103, respectively.
 
Best of luck out there this week,
KM

LONG ETFS
 
EWT – iShares Taiwan
With the introduction of “Panda Diplomacy” Taiwan has found itself growing closer to mainland China. Although the politics remain awkward, the business opportunities are massive and the private sector, now almost fully emerged from state dominance, has rushed to both service “the client” and to make capital investments there.  With an export industry base heavily weighted towards technology and communications equipment, Taiwanese companies are in the right place at the right time to catch the wave of increased consumer spending spurred by Beijing’s massive stimulus package.

XLU – SPDR Utilities We bought low beta Utilities on discount (down 1%) on 10/20. Bullish formation for XLU across durations.

FXC – CurrencyShares Canadian Dollar We bought the Canadian Dollar on a big pullback on 10/20. The currency ETF traded down -2%, but the TRADE and TREND lines are holding up next to Daryl Jones’ recent note on the Canadian economy.

EWG – iShares Germany Chancellor Angela Merkel won reelection with her pro-business coalition partners the Free Democrats. We expect to see continued leadership from her team with a focus on economic growth, including tax cuts. We believe that Germany’s powerful manufacturing capacity remains a primary structural advantage; with fundamentals improving in a low CPI/interest rate environment, we expect slow but steady economic improvement from Europe’s largest economy.

CAF – Morgan Stanley China Fund
A closed-end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the more volatile domestic equity market instead of the shares listed in Hong Kong. To date the Chinese have shown leadership and a proactive response to the global recession, and now their number one priority is to offset contracting external demand with domestic growth. Although this process will inevitably come at a steep cost, we still see this as the best catalyst for economic growth globally and are long going into the celebration of the 60th Anniversary of the People’s Republic.

GLD – SPDR Gold We bought back our long standing bullish position on gold on a down day on 9/14 with the threat of US centric stagflation heightening.   

XLV – SPDR Healthcare We’re finally getting the correction we’ve been calling for in Healthcare. We like defensible growth with an M&A tailwind. Our Healthcare sector head Tom Tobin remains bullish on fading the “public plan” at a price.

CYB – WisdomTree Dreyfus Chinese Yuan The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.

TIP – iShares TIPS The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield. We believe that future inflation expectations are currently mispriced and that TIPS are a efficient way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

 
SHORT ETFS
 
XLY – SPDR Consumer Discretionary Consumer Discretionary has rallied from the freak-out “short everything consumer” lows, prompting a short on 10/22 as a hedge for a TRADE.
 

UUP – PowerShares US Dollar We re-shorted the US Dollar on strength on 10/20. It remains broken across all 3 investment durations and there is no government plan to support it.

FXB – CurrencyShares British Pound Sterling The Pound is the only major currency that looks remotely as precarious as the US Dollar. We shorted the Pound into strength on 10/16.

XLP – SPDR Consumer Staples Strong day for Consumer Staples on 10/16, prompting a short versus our low beta long position in Utilities (XLU).

EWJ – iShares Japan While a sweeping victory for the Democratic Party of Japan has ended over 50 years of rule by the LDP bringing some hope to voters; the new leadership  appears, if anything, to have a less developed recovery plan than their predecessors. We view Japan as something of a Ponzi Economy -with a population maintaining very high savings rate whose nest eggs allow the government to borrow at ultra low interest levels in order to execute stimulus programs designed to encourage people to save less. This cycle of internal public debt accumulation (now hovering at close to 200% of GDP) is anchored to a vicious demographic curve that leaves the Japanese economy in the long-term position of a man treading water with a bowling ball in his hands.

SHY – iShares 1-3 Year Treasury Bonds  If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yields are going to continue to make higher-highs and higher lows until consensus gets realistic.