Chinese Real Estate - the Time Bomb keeps ticking

Back in April, I recommended selling the Chinese market short, a move which many thought "suicidal." Chinese industrial numbers at the time looked fantastic - and still do. Nonetheless, the Shanghai Composite Index tanked exactly as I suspected, going from 3130 to 2365, a 32% loss (providing a 32% gain for short-sellers) in only two and a half months.

The market has since recovered slightly (to 2560), and the world economic picture looks somewhat brighter. So the question is, should you finish taking profits or keep the short sale going?

Despite drastic government measures, the euphoric mood of the Chinese market appears to have barely subsided. Prices remain stratospheric. Speculation remains rampant. Gleaming condos continue to rise.

A Xinhua news agency article from July 24th (Realty trouble in the offing), recognized that the housing bubble is still out of control, bluntly noting that "skyrocketing housing prices are the outcome of artificial speculation." In addition to calling the market "bloated," it adds that price rises could result in "social conflicts and lead to social unrests."

No, the Chinese meltdown is not over. But, the market fall may take a short hiatus (ie. make a slight recovery) as the world situation temporarily improves. Hopefully not for long, however, since the longer the Chinese euphoria lasts, the more devastating the final fall will be. Be ready to sell short again when the market plateaus.
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This will likely be the last article for the next two weeks, as I am off to Shanghai to find out about the market firsthand.

Thank you for reading The Frost Report.
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Additional reading: Sell the Chinese Market Short
Big realty program to solve house woes
Foreign investors eye China's realty market

Truth or Dare - The Fed vs CNBC

In past articles I have emphasized the importance – no, the necessity – of getting the facts and then forming your own opinions, rather than having your opinions formed for you.

In a hilarious exchange (to me), the Federal Reserve on Wednesday released the minutes of their June 22-23rd meeting, while CNBC simultaneously released a series of articles and commentaries on the same topics as seen in the Fed’s report.

The Frost Report today contrasts the differences between fact and opinion, or, more specifically, the impressions created by a non-emotional source versus the impressions created by a source that is necessarily dependent upon ratings.
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The Fed
“The rise in consumer spending slowed in recent months after a brisk increase in the first quarter….The moderation in spending appeared, on balance, to be aligning the pace of consumption with recent trends in income, wealth, and consumer sentiment. Real disposable personal income moved up at a solid rate in March and April, reflecting increases in employment and hours worked as well as slightly higher real wages, but home values declined in recent months and equity prices moved down since the April meeting. Measures of consumer sentiment improved in May and early June but were still at relatively low levels."

CNBC
Economic Recovery Is Faltering As Shoppers Head to Sidelines
"Even Federal Reserve officials have rolled back their economic outlook for the first time in more than year, saying Wednesday that continued weakness in the job market is hampering growth."
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The Fed
“The anticipated expiration of the homebuyer tax credit appeared to have pulled home sales forward, boosting their level in recent months. Sales of existing single-family homes rose strongly in April, and, although they moved down in May, these sales were still above their level earlier in the year. Purchases of new single-family homes also jumped in April, but then fell steeply in May.”

CNBC
Home Sellers Slashing Prices, While Banks Mow the Lawn
"That heady buzz from the home buyer tax credit is now turning into a grinding headache, as home sellers realize their very temporary, government-induced catbird seat has now fallen back to earth."
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The Fed
"The staff's forecasts for headline and core inflation were also reduced slightly. The changes were a response to the lower prices of oil and other commodities, the appreciation of the dollar, and the greater amount of economic slack in the forecast. Despite these developments, inflation expectations had remained stable, likely limiting movements in inflation."

CNBC
White House Economic Adviser Sees Deflation Risk
"'Yes, it is a risk,' Romer replied when asked during a congressional hearing whether deflation was a risk. Romer also said she did not expect the economy to slip back into recession."
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The Fed
"In sum, the changes to the outlook were viewed as relatively modest and as not warranting policy accommodation beyond that already in place. However, members noted that in addition to continuing to develop and test instruments to exit from the period of unusually accommodative monetary policy, the Committee would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably."

CNBC
Fed Discussed Steps to Bolster Sputtering Recovery
"Federal Reserve officials cut their forecasts for growth this year and signaled they stood ready to take new steps to keep the recovery alive if the economy takes a turn for the worst."
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Great investors read annual reports (at least the financial sections) before purchasing a stock. They read complex Federal Reserve statements firsthand. They know that in order to be ahead of the game, they need to do the things that average investors do not. When it comes to information, they never take the easy way out. Great investors know that second-hand information results in second-rate decisions.
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Sources used in this article:
Minutes of the Federal Open Market Committee, June 22-23, 2010
Economic Recovery Is Faltering As Shoppers Head to Sidelines
Home Sellers Slashing Prices, While Banks Mow the Lawn
White House Economic Adviser Sees Deflation Risk
Fed Discussed Steps to Bolster Sputtering Recovery
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"I am suspicious of the idea of a new paradigm, to use that word, an entirely new structure of the economy."

Paul Volcker, former chairman of the Federal Reserve

The Canadian Real Estate Market: Trouble in the Pipeline

The Canadian Housing market is going well, with big volume and qualified customers. At least, that’s the current perspective at the end of the line. The further one goes up the pipeline, however, the worse the big picture looks.

A mortgage department employee from a major bank recently told me that application volumes are down 25% or more since June 15th. Though employees are not being laid off, those who leave or retire are not being replaced. At the same time, the quality of mortgage applications is deteriorating rapidly (“scraping the bottom of the barrel” was the exact expression).

Further up the pipeline, Real Estate agents tell me they are worried. Sales have dropped noticeably since May. In an attempt to make up the difference, agents are cold-calling and self-marketing like they have not done for a very long time.

Of course, all this is anecdotal evidence. At the bank level, sales numbers still look great. Yet, I suspect that the drying mortgage pipeline will reach Canadian banks soon. When it does, you will read about it here.

For further information, see:

Spin City
Canadian Debt II
World Housing Bubble II
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"Phew. With yesterday's report that home resales are cooling and price increases shrinking, we can finally put behind us the horror of Canada's great imaginary housing bubble. ...What Canada had was modest overvaluation with very little sign of speculation."

Jay Bryan, The Montreal Gazette, June 17 2010.

Buy High, Sell Low!

Or is it the other way around?



Ridiculed by professionals, “retail investors” are known for making terrible errors of financial judgement, including selling at the worst possible times, and keeping money in worthless investments. So what is a retail investor, and how do you avoid acting like one? To find out, ask yourself the following questions...

What is the difference between a stock and a bond?
What is the difference between nominal and real rate of return?
What is a P/E ratio?
What does a balance sheet tell you?
Why does the Federal Reserve raise interest rates to “cause” a recession?
What are the contents of a balanced mutual fund vs. an aggressive mutual fund?

If you do not know the answers to these basic questions, then you are a retail investor. That is, you are a person who invests money without really knowing what you are doing; therefore, you rely on news and opinions to make your investment decisions. What this article will explain then, is how to save you from yourself.

What marks the retail investor (RI) is fear caused by lack of understanding, occasionally accompanied by greed and Hubris - the belief that you know more than you actually do. The goal then, is to accumulate just enough understanding not to be a menace, while at the same time recognizing your limitations. The first step in this process is to understand how RIs behave, and how this differs from professionals. As a rule, RIs follow a pattern similar to the following scenario…

As the economy begins to recover from a recession, RIs remain sceptical (or scared and angry) and stay on the sidelines, putting their money into low-yielding GICs and money market funds, or under a mattress. They aren’t aware that when inflation is at 2% and their GIC yields 1.5%, they are actually losing money.

As the economy improves further and stocks begin to rise, RIs remain in cash. The market continues to rise, but with occasional drops (corrections) that keep edgy RIs out of the market, and leads them to believe that the market is "rigged" against them. Eventually, after stocks have risen significantly and the economy is well on its way to recovery, news stories of “excellent markets” begin to make headlines. At this point, RIs begin buying mutual funds and stocks in quantity.

The return of RI money to the market causes markets to rise. Seeing their stocks values improving, RIs get excited and put even more money in the market. Markets rise dramatically and stocks become overpriced. The fantastic economy makes front-page news. Neighbours of existing investors, not wanting to miss out on getting rich, join the party. News reports explain that this economy is different from all others before it (due to the Internet, Globalization, rise of China, or some other excuse) and that therefore the good times will never end.

Consumers –flush with cash - go on a spending spree that causes wage increases, labour shortages and inflation. Workers in their early 20s skip work to go to the beach, confident that if they get fired they will be able to find a new job within days. Industrial workers who normally don’t save a dime start buying as if they are high-rollers in Vegas.

The Federal Reserve begins to warn professional investors using cryptic phrases such as “irrational exuberance” or “froth” to describe the overheated market. Professionals start selling their overpriced stocks to euphoric mechanics and pizza-shop owners. To cool down the economy, the Federal Reserve raises interest rates so that fewer people can get loans to buy homes, cars etc. With the decline in business -- or in anticipation of it -- stocks drop slightly. Professionals buy bonds or put their money in cash.

RIs don’t worry about the decline in their stocks, because they know that the economy is doing spectacularly well: the media says so. Stocks drop more. RIs still feel confident. Stocks drop more, making the news. Although RIs begin to worry, they remind themselves that they are “long-term investors” and will simply wait for prices to rise again. Analysts warn of a difficult market. Consumers spend less. Stocks drop further. Finally, unable to sleep at night, RIs start selling their mutual funds.

A wave of selling brings reduced prices and still more selling. Panic sets in. Financial news anchors start babbling hysterically and arguing with their guests. Retail news agencies announce that we are in a recession, that life is terrible, and that the horrors may never end. Retail stock writers pen articles warning people that they may lose “everything.”

After days or weeks of frightening stories, financial news anchors finally run out of adrenaline and become gloomy and exhausted. The evening news tells the story of a lady next door who saves $10 a week by using cooking oil to power her car. Another story explains how to save money by using coupons. Shortly thereafter, Wall Street professionals announce that the stock market has hit a low plateau – all the retail investors have finished selling! Professionals buy. As they are buying, they make TV appearances warning retail investors not to buy, since it is still very risky.

And so the cycle continues…whether it be (as is this story) with stocks; or, with oil, gold, real estate, tulip bulbs, or frozen concentrated orange juice.

Although everyone knows that to make money in the market you have to “buy low and sell high,” retail investors typically do exactly the opposite: they are so afraid of losing money that they consistently lose money.

To be successful in the market, you must conquer your fears surrounding money. You must "buy low and sell high," which in practice means “buy pessimism and sell euphoria.” That is, you have to buy at a time when everyone else is afraid to do so.
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"They are stupid, the dumb money that always gets beat up. Retail waits until a stock works, and only then buys it. They they complain when it goes down. Or they won't sell something that works, convinced it's going higher, and then blame you when it blows up. Stay away from all of them. Use garlic and crosses if you have to."

Tom McDermott, as told to Andy Kessler in "Wall St. Meat"

The US Economy - Headed in the Right Direction?

Today, Barack Obama announced that the US economy is "still headed in the right direction," a comment that induced a great deal of ridicule, especially after this week's dismal employment figures. Yet, Barack Obama is right - the economy is headed in the right direction, though it has little to do with his great leadership, or his lack of it.

Interest rates are low & housing prices are low, together creating the best affordability rates since the 1950s. At the same time, many stocks are trading at below book value (net asset value). These are prime conditions for economic recovery. No matter what other government programs or policies are in place (or not), the economy will be in far better condition two years from now than it is today.

The economic cycle is playing itself out, textbook style. If Bill Clinton, George Bush, Ronald Reagan (also a chronic spender) or anyone else were still in office, we would be at exactly the same point.

The tendency for people to overemphasize the significance of an individual's actions is known as "fundamental attribution bias." As an example, the Vice-President of a bank recently told me that he became Vice-President at the "worst possible time" – just before the recession hit - thereby making his sales and leadership abilities look terrible. The economy is still bad and people are frustrated, so they are blaming Obama for everything except breathing.

Now that the major requirements for recovery are in place, the actual pace of the recovery is not within Obama’s – or anyone else’s – locus of control. Just as Bush was unable to prevent the crash, Obama is unable to speed up the recovery.

This time of maximum pessimism is, as I have stated on previous occasions, a buyer’s dream. Take advantage of it by purchasing the stocks of great companies at low prices. That is, buy low and sell high – unless you really believe that the world is ending.
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"Until people feel better about their own lives, they're not going to feel better about the president."

Bill Clinton, regarding Barack Obama, 2010
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Stocks I Like - Citigroup

Citigroup – the company that almost went bankrupt in the subprime credit crisis, that received billions of dollars in government aid, and whose management has been called inept – is on my buy list.

Collectively, mutual funds and other large retail investors cannot buy Citigroup, because their unit holders would go berserk with worry. After all, the news surrounding Citigroup has been nothing short of scandalous. This situation presents an opportunity for the astute investor. For those who invest using logic rather than emotion and who can think beyond the next quarter, the big “C” is a great buy.

First off, the price: $3.79 per share at last close. This puts Citigroup shares at well below book value. As I wrote at the end of May, “At the moment, you can buy $5.61 worth of Citibank assets for $3.81, and get all their clients, brand names, and worldwide businesses for free.” And what a franchise it is.

Outside of the US, I have used Citigroup banks in Delhi, London, Tokyo and Beijing. Citigroup is a global business powerhouse, and its image - though tarnished at home - is relatively unscathed elsewhere. Citigroup’s worldwide reach is enviable.

The price of C has been hovering at just under $4 for weeks, and will likely stay there until the US government finishes selling its ownership - 2.6 billion sold so far, with 5.1 billion more to go. So, there is certainly no rush to get in. However, once the government’s stake is gone, Citigroup’s price will likely move sharply upward.

In a couple of years, I would not be at all surprised to see Citi’s EPS rise to the $2+ range, which at a modest P/E of 10 would give the shares a price of $20. Nice.

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"If a person is not willing to make a mistake, you're never going to do anything right."

Sandy Weill, former CEO of Citigroup
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Disclosure
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.