In spite of the random walk theory, which tells us the movements from day to day are random, anyone who's ever looked at a stock chart has certainly seen wonderful trends. Trends that go on forever in a given stock, sector or market. Trends with a very predictable path.
It's this type of movement that we all dream to catch. But how do these trends produce themselves? While at times it's just the movement of the herd that perpetuates itself, the majority of long-lasting trends need institutional participation to be born and sustain themselves. The trends need sources for buying and selling, which are nearly limitless.
And why do these entities, these institutions, decide to spend so much time on the same side of the market, in a given stock or sector? This happens because usually there's a theme, a thesis, which validates those positions. This theme/thesis repeated by hundreds of research analysts and conveyed by thousands of sales persons in contact with the institutional traders or large private investors, generates a constant flux of orders (order flow), which eventually creates and sustains a trend.
And this goes on until one day the thesis is no longer true, or as we've seen multiple times, the thesis is taken so far that it generates a bubble, which then explodes due to the exhaustion of the exponential sums of money it needs to keep on growing.
So there you have it. A theme/thesis creates a trend. So when we're facing a strong trend, the first thing we need to understand is the theme behind that trend, for at least two reasons:
- So we can evaluate whether the theme justifies the market values or whether these have already gone too far;
- So we can understand what facts will confirm the thesis, and what facts deny it.
Our first 3 themes
This article will be the first on a series of articles summarizing themes, which are moving specific sectors or markets today. Knowing these themes can help when selecting securities. I'll start with the following three themes:
- China investment -> consumption switch;
- U.S. Quantitative Easing.
China investment -> consumption switch
China's economy was until recently based mostly on investment. Nearly 50% of China's GDP came from capital formation. As a term of comparison, the U.S. stands at 16%. Over the next few years, this is expected to change, with the Chinese economic growth relying more on consumption and less on investment.
China moving toward consumption has very significant implications for Western companies serving the Chinese market, namely those companies that have valuable brands. Brands like BMW, Microsoft (MSFT) or Apple (AAPL) are highly favored by an increase in Chinese consumption.
For any consumer-facing company, one needs to always ask how an increase in Chinese demand will impact it. At the same time, one might do well to consider the same for suppliers to those companies. For instance, Intel (INTC) might gain from increased Chinese demand, because of an increase in sales of PCs and servers there.
One does need to be aware that China will be able to satisfy much of its increased appetite for consumption - only those brands and products, which will face less internal competition, will tend to be favored.
China is the largest consumer for many materials whose intensity is much greater in an economy undergoing an investment boom, than it is in an economy undergoing a consumption boom. Basic materials like iron, steel, copper, etc, where China consumes and/or produces more than 50% of the world's output will see significant downward pressure from this economic change.
At the same time, China's previous expansion produced booms in some of these materials, which now appears as unsustainable. Iron ore producers like BHP Billiton (BHP), Rio Tinto (RIO) or VALE (VALE) are already suffering from this change.
China's massive production capacity in steel is also likely to produce a major depression in this sector on a worldwide scale. This is already ongoing and will probably only stop with the bankruptcy of several steel producers, both in China and abroad. This is a major risk for Western steel producers like U.S. Steel (X).
"Abenomics" is the renewed Japanese economic policy that relies on huge fiscal deficits and freewheeling money printing to reach a number of objectives, such as:
- Seeking to foster 2% inflation, thus killing the deflation monster;
- Seeking to finance the said giant deficit and public debt stock while keeping interest rates low;
- Seeking to unleash a wealth effect, by making the owners of assets feel wealthier and thus lead them to spend more freely;
- Seeking to devalue the Japanese yen. This should lead to higher exports and higher investment in domestic production capacity.
Obvious winners from Abenomics are domestic asset prices, from real estate to stocks. Stocks can be played by foreign investors by investing in hedged funds like WisdomTree Japan Hedged Equity (DXJ). Rather more risky would be to play this theme through an ETF like iShares MSCI Japan Index (EWJ).
The main risk here is that while the Bank of Japan monetary madness is positive for asset prices, it's also negative for the Japanese yen. It's not impossible that the Japanese yen ends up losing more than what the assets gain.
Also favored by this policy are individual shares of Japanese exporters such as Sony (SNE), which can be bought as ADRs on the U.S. exchanges.
Abenomics does not produce just winners. For starters, it's deeply negative for the Japanese yen (FXY) given all the currency printing. Then, it's also negative for those countries and companies, which are Japan's direct competitors, namely Korean producers. In terms or Western markets, it might be possible to play the effect through ETFs such as iShares MSCI South Korea Capped Index (EWY) or The Korea Fund Inc. (KF). There is the slight problem that monetary easing can also be positive for equities worldwide, though.
Abenomics can also punish Western companies selling in Japan, by making revenues and earnings in yen be worth less in the domestic currencies.
Finally, Abenomics could lead to competitive devaluations, could produce hyperinflation in Japan and in an extreme case, could even lead to wars between countries, though that seems very unlikely at this point.
U.S. Quantitative Easing
Quantitative easing, along with ZIRP (Zero Interest Rate Policy), forms the cornerstone of the current U.S. monetary policy. This policy is similar to Abenomics in Japan, with similar objectives, beneficiaries and problems.
Quantitative easing consists in the Federal Reserve printing currency and buying assets - presently Treasury bonds and MBS (Mortgage Backed Securities). The Federal Reserve is doing this to the tune of $85 billion per month. The sellers of these assets turn around and substitute the assets they've sold, which leads to buying mostly in direct substitutes (other bonds, corporate bonds, high yield). A smaller amount bleeds toward indirect substitutes, like equities. In the end, mostly every asset - and especially every yielding asset - gets inflated.
The objectives of this policy are, as I said, similar to Abenomics, so it:
- Seeks to foster inflation;
- Seeks to finance the large fiscal deficit;
- Seeks to unleash a wealth effect, by making the owners of assets feel wealthier and thus leading them to spend more freely;
- Seeks to devalue the U.S. dollar. This should lead to higher exports and higher investment in domestic production capacity.
The U.S. monetary orgy affects all assets' prices positively. But its stronger influence is in direct substitutes for the assets being bought by the Federal Reserve, so other bonds are affected most strongly. This is especially noticeable in high-yield bonds for which the iShares iBoxx $ High Yield Corporate Bd ETF (HYG) or the SPDR Barclays High Yield Bond (JNK) are proxies.
The effect is somewhat less pronounced in public debt (Treasuries) because these are being issued in large numbers due to the large fiscal deficit.
Though on a smaller scale, the effect is also transmitted to the equity markets, for which a broad Index ETF like the SPDR S&P 500 (SPY) is a good proxy.
This policy has been going on for a while, we're into QE3 already, and right now we're near a tapering (reduction) process, so it might be too late to take advantage of the present instance. However, it's likely that as the Federal Reserve removes stimulus, the markets will once again plummet and the Federal Reserve will be back for another round. So basically the best way to take advantage of this lunacy will be to buy any deep plunge after the policy is temporarily removed.
Finally, the aging of the U.S. population together with the pension and healthcare promises should be enough to destroy the fiscal budget going forth, and thus should ensure more money printing in the long term. Only inflation of a currency implosion seem to stand as possible obstacles for renewed printing.
The limits to an endless money-printing campaign are usually two, and they're intertwined: inflation and currency debasement. Short of a spurt of inflation and a dollar massacre, it's likely that the option to print will always be chosen above any possible pain.
Every time the printing is suspended, however, it's also likely that the markets will plunge, perhaps even quickly (in flash-crash fashion). This is to be expected, since while the printing goes on the tendency to take on leverage is strong, and leverage without printing support leads to quick crashes.
I'd say that investing in TIPS or foreign currency would be two possible defenses for the downside of endless USD money printing.
These are just the first three of many different themes running through the markets today. Some of these themes will have an effect on specific sectors, whereas others will be more general. Two of the themes in this particular article (Abenomics and the U.S. quantitative easing) are the reason why markets have been rallying nonstop since November 2012. The U.S. money-printing campaigns have also been responsible for every rally since November 2008. Given how distorted things are turning, it seems likely that the foreseeable future will also be dictated mostly by future monetary campaigns, or their absence.
Still, laying testament to the power of other themes, the basic materials sector has not participated in the present monetary-fueled rally. The reason is the Chinese transition, which I also explained in this article.
Anyway, this is but the first of a series of articles, and there are many other interesting (and less well-known) themes coming up. Stay tuned.