"We risk becoming the best informed society that has ever died of ignorance"
- Rubén Blades

"You can't make up anything anymore. The world itself is a satire. All you're doing is recording it"
- Art Buchwald

"It's getting exciting now, two and one-half. Think of everything we've accomplished, man. Out these windows, we will view the collapse of financial history. One step closer to economic equilibrium"
- Tyler Durden

"It is your corrupt we claim. It is your evil that will be sought by us. With every breath, we shall hunt them down."
- Boondock Saints

Monday, December 20, 2010


Dear Reader,
     The global markets have begun to deviate from the traditional norms.  Beginning in the late 1990s and leading up to 2007, global current-account balances signaled a shift in the fundamentals of economics.  Not so much as the overriding theory changed but it was the behavior of the participants that led to the perfect storm we, in developed nations, were forced to experience.  

     The data has shown that debtor nations have, through the principles of conservative money management, been able to transition themselves to creditor nations.  They have been able to tax the income revenue off investments in their boarders and use it as loans to the US, essentially increasing their claims against the US as creditors. 

     Investors require a premium (rate of return) above what they would receive on a risk free asset, when they embark into risky investments or speculation.  This premium can be lowered in geographical locations with cheap labor costs and with less, if any, sophisticated economic markets.  When the ROI is lowered, investors and traders begin to take on leverage in an effort to increase the size of their returns and when money is cheap, as it is now, the leverage levels can reach mind blowing proportions (Lehman was 40:1, for every $1 Lehman invested, they added $40 of leveraged liquidity).  A large proportion of the talking heads on TV have blamed the cheap money on the Federal Reserve.  If you look only at the FFR, this may be a viable conclusion; however I must say it would be infant like to view economic activity in such a narrow realm.  The Fed lowered the FFR in an effort to decrease the spread that it had when compared to the LIBOR (See the chart after this paragraph).  What we must realize and calibrate our thinking to is the reality of the flow of money from Sovereign Nations and from industrial nations to the safety of the US.  This results in capital shifts from developed nations to industrial nations.  

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     On the first chart below, the housing market peak is labeled from 2005-2006.  The red line represents the peak in the  Russel 2000 prior to the months leading up to the crash of Lehman.  What we hear of now is China's great boom which was aided by the run up of the Hang Seng Index and the ability of firms to raise capital through equities and bonds.  China's government took the revenue they generated from their income tax and saved it.  As the US financial markets depreciated, China used its excess reserves as loans to US Banks.  Foreign money is also appreciative to the safety and certainty of US Treasury Holdings.  Sovereign Wealth Funds need not worry about run away inflation as they do in other, less developed markets or that the US regime will be overthrown and all the investments are confiscated. 

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     The industrial nations pull this liquidity from the system in the form of savings.  The odd behavior comes about when the industrial nations decide to save their money and not spend it, thus resulting in the less developed (poor) countries saving (lending) money by storing liquidity in assets that have been created by developed and sophisticated markets.  As it goes, the poor lend to the rich; a polar opposite to what is recorded in my university economic textbooks.   

     One of the issues that alter the way we navigate these markets will be how we value assets, aside from how we educate the up and coming managers of this system which I'll save perhaps for a later time.  I'm in a new realm now myself, having built valuation models over the past three years based on lasting, old school principals.  I'm an advocate for the old school Ben Graham and David Dodd style of participating in a monetary system.  The way we go about buying stocks should be similar to when we make medium sized purchases.    I write medium  sized purchases because most people will not study the universe of possibilities when they "invest" in a house or a college education, the two largest investments people make.  Most people when they buy a home do it based on narrow criteria and without a deep understanding of how the housing system valuations are tied to the world monetary system.  Rational people will establish a level of marginal utility they expect to receive and then they will compare prices, in most instances, to find which gives the most utility for the least dollars per unit.  This is how I purchased equities, based on comparative ROI and risk (measured with the Normal Bell curve, fat middle, small tails).   The problem now is that we have incredible sums that flow from Sovereign Nations with less sophisticated securities, to nations with more sophisticated securities that offer better certainty and acceptable risk, thus resulting in a flatter curve with fatter tails and a compressed bell.

     Back in the day, the system as a whole was more predictable.  As debt problems arise from the recent crisis, the flow of money and the size of that flow has been enlarged.  When the EU has speculators driving up the rates on a nations Credit Default Swaps, the nation pays more to borrow money and this in turn creates unexpected stress on expenditure levels.  Once the "noise" of increasing rates becomes a reality, investors move their money to more stable regions.  This will cause undue price appreciation for bonds, equities and currency spot rates.  To get out in front of those big banks who have inertia pushing them to the thought of "this is noise, things will go back to normal", we, as individual participants, need to calibrate our thinking and find value in the predictably irrational behavior of the big money.

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