Emerging Markets’ Desperate Need for Renewables

In our October 28, 2013 commentary (“An Early 21st Century Narrative: The Age of Renewables“), we asserted that–due to increasing domestic crude oil production and the ongoing adoption of renewable fuels–U.S. energy independence on a national level is a foregone conclusion. The Energy Information Administration (EIA) chronicles that last year, as much as 84% of total U.S. energy demand was fulfilled by domestic sources, the highest level in 30 years.

Exhibit 1: U.S. Energy Production at 30-year High Relative to Consumption

domesticproduction2013

Interestingly, 10% of our domestic energy production now comes from renewables (including hydro, solar, wind, biofuels, and thermal). We believe government agencies in general are too pessimistic regarding the trajectory of the increasing impact of renewables on U.S. and Developed Markets’ energy production. For example, Germany (a country not known for its sunshine) recently generated over half of its electricity from solar for the first time, while Great Britain’s installed solar capacity doubled over the last year–none of which anyone has foreseen. Because of the rapid adoption of renewables, as well as the ongoing shale revolution, we continue to believe that U.S. energy independence on the national level is a foregone conclusion.

What we are more interested in–as investors and global citizens–are two more ambitious goals: 1) energy independence at the community or household level through microgrids and a “smart,” decentralized distribution system, and 2) bringing electricity and heating to more undeveloped areas of the world. The International Energy Agency (IEA) estimates that 1.3 billion people today are still without access to electricity, while 2.6 billion people have no access to clean cooking facilities.

This is a glaring social problem not just in Sub-Saharan Africa but in other developing countries/regions, such as India, China, and Developing Asia. e.g. The IEA contends that as much as 25% of India’s population today have no access to electricity. A country where a vast segment of its population is disenfranchised is both a significant impediment for future economic growth and social harmony.

According to the IEA’s 2014 World Energy Investment Outlook, global policy makers and corporations are projected to invest $40.2 trillion into our energy production and transportation infrastructure from now till 2035. 59% of these funds will be used to maintain current production, while 41% will be for new development. Two interesting trends are expected to continue over the next 20 years:

  1. There is a decisive trend towards investing into renewables and efficiency programs in both developed and emerging market countries;
  2. The role of public policy makers in shaping global energy policy has been on the rise, and will continue to rise for the foreseeable future as governments set goals for renewables adoption (e.g. California’s 33% renewables goal by 2020) and new efficiency standards.

Within the developed world, these two trends are driven by environmental and domestic energy security concerns. Within Emerging Markets, however, these are driven by more fundamental concerns. For example, economic growth and the rising cost of energy has led to a significant deterioration of China’s and India’s trade accounts in recent years. The rising cost of energy (combined with significant gold imports) was instrumental in causing India’s financial crisis last summer.

Exhibit 2: Oil Import Bills of Net Importing Developing Countries on the Rise (source: IEA)

oilimportbillEMSince 2011 (the IEA’s last study on Emerging Markets’ energy imports), energy dependence in countries like China and India has continued to rise. In fact, China’s oil imports are projected to rise above that of the U.S. sometime this year. As such, investments in renewables in both China and India are not only necessary due to environmental concerns, but national security concerns as well.

Finally, as discussed above, there is also a dire need to empower those who currently have no access to electricity in many developing countries, including India. This is crucial to sustain high economic/productivity growth, as well as for long-term social cohesion (having electricity inherently increases access to education, knowledge, and healthier lifestyles). The IEA estimates that an additional $641 billion in investments is needed to achieve universal access to electricity by 2030, $135 billion of which is needed in India. In light of the $40.2 trillion of projected investments in the global energy sector over the next 20 years, $641 billion is achievable. However, the IEA also stresses that much of these investments would need to be made in rural areas with little or no access to any existing infrastructures (e.g. power lines or even paved roads). Since the costs of building a centralized grid (or expanding the current grid) to rural areas are prohibitively high, the only alternative is to install microgrids or roof-top solar in such undeveloped rural areas. The age of renewables will thus not only bring U.S. energy independence, but increased energy access to the rest of the world as well.

 Exhibit 3: Additional Investment Required for Universal Access to Electricity ($billion in year 2010 dollars; source: IEA)

energyaccessforpoor

The Education of the Millennials

Published in 1907, The Education of Henry Adams is a meditation of the immense shifts in the political, economic, social, and technological landscapes of 19th century America during the Second Industrial Revolution. While granted a first-class education, Henry Adams–the great-grandson of John Adams and grandson of John Quincy Adams–would lament throughout the book that his formal education in the classics and history never prepared him for the scientific and technological revolution of the late 19th century. Quoting the book (narrated in third-person):

At any other moment in human history, this education, including its political and literary bias, would have been not only good, but quite the best. Society had always welcomed and flattered men so endowed. Henry Adams had every reason to be well pleased with it, and not ill-pleased with himself … Only on looking back, fifty years later, at his own figure in 1854, and pondering on the needs of the twentieth century, he wondered whether, on the whole the boy of 1854 stood nearer to the thought of 1904, or to that of the year 1 … The calculation was clouded by the undetermined values of twentieth-century thought, but the story will show his reasons for thinking that, in essentials like religion, ethics, philosophy; in history, literature, art; in the concepts of all science, excepts perhaps mathematics, the American boy of 1854 stood nearer the year 1 than to the year 1900. The education he had received bore little relation to the education he needed. Speaking as an American of 1900, he had as yet no education. He knew not even where or how to begin. (emphasis mine).

A cursory review of U.S. history suggests that the Millennials (a demographic group typically defined as those born between 1980 and 2000) have already experienced profound political, social, and technological changes in their short lifetimes unmatched by previous generations, with the possible exception of those who: 1) fought the American Revolutionary War, 2) the American Civil War, 3) experienced the Gilded Age, or 4) experienced the Great Depression and fought in World War II. Many historical seismic shifts in the American cultural fabric were bloody; some not (e.g. the influx of more than 25 million European immigrants from 1850 to 1930).

Further review of these societal shifts suggests one common, and very important, attribute: With the exception of the various waves of immigration, none of these were uniquely American. However, all of these have ultimately made America stronger on the global stage, beginning with American independence in 1776.

Fast forward to today, and the Millennials (also known as the Gen-Ys) are struggling. We believe we could distill this into three major causes:

  1. The U.S. labor market is no longer protected: Relative to Europe and Asia, the U.S. has always had a chronic shortage of labor, resulting in relatively high wages and the subsequent creation of a middle class. Post Civil War and Slavery as an institution, the Gilded Age was a glaring exception, as waves of immigrants served to depress wages for manual labor. The creation of a U.S. middle class after WWII was enabled by a significant curb in immigration beginning in the late 1910s, as well as the democratization of higher education and a general shortage of labor after WWII. The fall of the Berlin Wall in 1989, and the subsequent commercialization of broadband internet and cellular networks, has resulted in an unprecedented shift in the old Labor vs. Capital debate. We believe the acceleration of automation in the U.S. economy will shift this debate further as more manual labor (including those who engage in complex, but repetitive tasks, e.g. fast-food workers or coffee baristas)  is replaced by machines over the next 5-10 years;
  2. The rapid pace of change in the U.S. labor market: Most of us fear change; however, we also secretly crave it, but only if implemented gradually. The rapidity of the shift in the labor market caught many Americans by surprise. In 1901, the Wall Street Journal summarized the immense consolidation of U.S. industry with the comment: “God made the world in 4004 B.C. and it was reorganized in 1901 by J.P. Morgan.” Carnegie Steel–which formed the basis of the $1.4 billion IPO of U.S. Steel in 1901–was founded only just 25 years before, while Standard Oil was founded as recent as 1870. With the exception of Google and Microsoft, many of today’s largest companies were founded more than 50 years ago. However, business practices have shifted immensely over the last 25 years. The mass adoption of outsourcing and automation by U.S. companies–along with an influx of college-educated Gen-Ys into the labor market–has depressed wage growth significantly. Defined benefits pension plans are no longer offered (or valued), and unemployment among young, college-educated workers are near record highs. Such experience by the Millennials is encapsulated by a recent NY Times article chronicling “the rise of the serial intern.”  The world has been reorganized and rearranged in a way such that today’s U.S. labor market bears no resemblance to that of 1989, when the Gen-Ys were still being educated on the wisdom of obtaining a college degree at all costs.
  3. The lack of a 21st century education and the rise of a highly educated global workforce: Year after year, the OECD PISA (Programme for International Student Assessment) shows that American kids are continuing to fall behind their global counterparts in terms of K-12 education. There are many reasons for this (lack of accountability by schools and teachers, lack of respect for the teaching progression, different cultural emphases for formal education, etc.); but more important, even kids who graduate with a four-year college degree have had little preparation to compete in today’s highly educated global workforce. I believe the main problem is this: The modern university system does not sufficiently prepare college graduates to compete in the 21st century global economy as it was engineered with the 20th century industrial economy in mind. Even the emergence of college entrepreneurship programs is a relatively recent phenomenon. e.g. The Arthur Rock Center for Entrepreneurship at Harvard Business School only opened in 2003, and the Polsky Center for Entrepreneurship and Innovation at University of Chicago opened in 1998. Furthermore, only a selected number of universities offer undergraduate courses or experiences in entrepreneurship (neither Harvard nor University of Chicago does). Moreover, most Americans remain U.S.-centric in nature; most U.S. college graduates have never resided or worked overseas. The challenge of working and collaborating with those from foreign cultures will be one of the main challenges for Gen-Y workers over the next 5-10 years.

The ongoing struggles by Millennials are exemplified by the following charts, courtesy of Goldman Sachs.

 Chart 1: A Sign of the Times… Today’s Millennials Are Less Employed

(16-24 Year Olds Labor Force Participation Rate)

 MillennialsLaborParticipation

Chart 2: And Millennials’ Average Income Have Been Declining Relative to that of the U.S. Labor Force

(15-34 Year Olds’ Average Income as a % of U.S. Labor Force Average Income)

 MillennialsAverageIncome

The struggles of the Millennials are real, and will have real implications for U.S. society and the global economy. In our last commentary (“Engaging with China as a Global Economic Superpower“), we addressed the need for U.S. leaders to engage with China as the latter rises to become the world’s biggest economy over the next 6-8 years. This is a job for the Millennials, as most baby boomers and Gen-Xers are too far entrenched in their attitudes and work habits to adapt to a globalizing workforce. Most important, U.S. consumer spending will be driven by Millennial spending growth over the next five years (3.4% annualized), easily crowding out the impact of the Gen-Xs (only 0.6% growth). In fact, total consumer spending by Millennials should surpass that of the Baby Boomers by 2020, making Millennials the largest spending cohort in U.S. history. Just as the Baby Boomers dictated every major societal and economic trend since the end of WWII (from the adoption of disposable diapers to the Civil Rights movement), the Gen-Ys will be driving similar trends for decades to come. The Education of the Millennials continues…

Chart 3: Projected U.S. Annualized Spending Power Growth by Generational Cohort

(2014-2019)

MillennialsSpendingPower

Engaging with China as a Global Economic Superpower

Last Wednesday, the World Bank declared China would overtake the U.S. as the world’s biggest economy on a PPP basis by the end of this year. The practice of utilizing PPP in comparing economic output across countries has become less useful as global trade and cross-border asset flows continues to grow as a percentage of the global economy. Yes, your US$ still gets you further in China than in the U.S. on average; and the median Chinese urban household still earns less than 20% of the median U.S. (both urban & non-urban) household. But this ignores the fact China is the world’s biggest importer of commodities such as copper, iron ore and precious metals–all of which are settled at world market prices which PPP has no bearing upon. Chinese economic output measured at PPP also ignores the fact that real estate prices in Tier-1 cities such as Beijing and Shanghai are now on par with those in New York and Los Angeles. Seen in this light, a Yuan actually goes further in a major U.S. city such as Houston or Dallas than in Shanghai or Beijing. Since Americans are generally much more mobile than the Chinese (which in theory allows a U.S. family to resettle to lower cost-of-living areas), a comparison between U.S. and Chinese economic output using PPP is highly misleading.

That is not to say it isn’t a worthwhile exercise. At the very least, the World Bank study has again put the Chinese economy, leadership, and corporations in the spotlight as the “Central Kingdom” re-asserts herself, first in the global economy, and second, in global geopolitics. Work done by the late British economist Angus Maddison suggests China’s share of global GDP was over 30% as recent as 1820. At their respective peaks, total economic output of China and India together made up approximately half of global GDP during most of the last two thousand years, with the exception of the last 200 years.

chinaindiaworldeconomyhistory

As students of Asian history, the above chart comports with our understanding of the history of the Chinese dynastic system, and its subsequent decline (note that pre-1368 A.D. data–i.e. pre-Ming Dynasty–is almost non-existent, e.g. the invasion of the Mongols and its impact on China during the early 1200s does not register in the above chart). The relative decline of China’s influence as the Ming Dynasty retreated from global trade–along with a costly war with Hideyoshi-led Japan–could be seen in the above chart. The decline in Chinese relative influence accelerated in the early 1600s as the Ming Dynasty weakened, with the dynasty eventually falling due to corruption, inept management, bad harvests, and the Manchu invasion during the early to mid-1600s.

Under the Manchu-led Qing Dynasty, however, the Middle Kingdom regained her former glory. The Qianlong Emperor (who ruled for 60 years and interestingly, would die in 1799–the same year that President George Washington died) ruled an empire unprecedented in size–encompassing both Mongolia and Tibet. By 1790, the population of the Qing Empire soared to over 300 million, or just under the U.S. population today. Chinese relative economic output would peak soon afterwards at nearly 35% of global GDP.

According to Professor Maddison and Professor Dwight Perkins of the Harvard Kennedy School, what was most impressive about China during most of her history was not its sheer population growth; nor the size of her empire. What was most impressive about the Chinese economy was her successful response to population growth–i.e. her ability to sustain per capita consumption over time even as population grew. The Chinese drove productivity growth in agriculture through increased use of fertilizers, irrigation, development of crop varieties, as well as published and distributed agricultural handbooks to spread “best practices” in farming. New crops from the Americas–which could be grown on inferior lands–were also introduced.

In other words, China has a rich history of innovation, adaptation, and engaging herself with the rest of the world. By the early 19th century, however, China’s 2,000 year-old dynastic system was no longer a suitable governing system for a fast-changing, industrializing world. As innovation and change swept the world, the Chinese ruling class hung on to outdated concepts and actively discouraged reforms–including the emphasis of science/math over the “classics” in the Imperial Examination. The rigidity of China’s ruling class and system during the 19th century made her vulnerable to foreign influence and invasion. The subsequent experimentation with Communist ideology in the early 20th century would prove disastrous. All in all, it took over 150 years for China to recover and to be recognized as a global economic power once again.

The latest World Bank study is thus timely, as both China and the rest of the world need to begin addressing the consequences of China rising to become the world’s #1 economy. Consensus suggests China will surpass the U.S. in nominal GDP by 2019 (as recent as 2003, Goldman Sachs believed China won’t surpass the U.S. until 2041). e.g. Chinese battery maker BYD experienced significant growing pains due to the company’s inexperience when it opened its North American HQ in Los Angeles. As Chinese influence continues to grow around the world, there will be inevitable clashes over business practices, cultural  misunderstandings, and increased competition (including those for real estate and college applications). As an investment bank who actively engage in U.S.-Chinese cross-border transactions, CB Capital has had first-hand experience in working with Chinese companies and cultures. We are also engaging with other U.S.-Chinese cross-border groups to cultivate closer relationships between local U.S. and Chinese/Hong Kong companies.

Sure, China is experiencing growth challenges, but this is to be expected. In particular, we are watching three issues very closely. As we have discussed, the Chinese “demographic dividend” is over. We expect Chinese real GDP growth to be in the range of 5%-8% over the next several years. China’s population growth has sunk to just 0.47%, ranking 159th in the world. By 2020, the Chinese demographic pyramid will be more inverted than that of the U.S. Another challenge is China’s unprecedented credit growth over the last five years, which was fueled by the country’s well-intended but poorly-executed US$586 billion fiscal stimulus package in 2008-09. A final challenge–which comes with the territory of being potentially the world’s #1 economy–is China’s dependence on foreign energy imports. China as we speak is making slow but steady progress on shale gas, but the country’s oil consumption growth remains unabated. In fact, the Energy Information Administration (EIA) expects Chinese oil imports to surpass those of the U.S. sometime this year. Energy security will thus become an increasing concern for China over the next several years.

Chart 2: China to Become World’s #1 Crude Oil Importer in 2014

globaloilimports

Short-term Deflationary Pressures Mean More Downside for Gold Prices

We became bearish on gold prices in late 2012, and first articulated our $1,100-$1,300 price target in our January 25, 2013 global macroeconomic issue–when gold traded at $1,660 an ounce. Over the last 14 months, we have reiterated our bearish views on both gold prices and gold miners; in our July 7, 2013 commentary (“A Technological Revolution in the Making – The U.S. Giant Awakens“), we further lowered our price forecast to $1,000-$1,200 an ounce, and asserted that the price of gold will hit bottom by the end of the 1st half of 2014.

At the time of our July 7, 2013 commentary–when gold traded at $1,220 an ounce–we asserted that the two most reliable indicators for at least a tradeable bottom were absent. Quoting our July 7, 2013 commentary:

The two most reliable psychological indicators for a tradeable bottom in any asset class are: 1) Panic, or 2) Indifference. The best time to invest in any asset class is after years of investors’ indifference. That–along with other screaming buy indicators–was the reason why I invested in physical gold and unhedged gold miners at under $275 an ounce in late 2000.

In this commentary, we reiterate our $1,000-$1,200 price target, but are pushing our forecast to 2Q-3Q this year. In addition, we are revising down our absolute bottom from $900 to $850 an ounce, as the marginal cost (both all-in-sustaining and pure extraction costs) of production has come down substantially over the last 18 months (the price of gold traded at the marginal cost of extraction various times during the 1990s bear market). Here are our reasons:

After nine more months of trading, gold investors have neither panicked nor capitulated. While gold ETF holdings have declined from a peak of nearly 85 million troy ounces in late 2012 to just 56 million troy ounces today, COMEX gold net speculative long positions remain elevated at more than 15 million troy ounces (see Figure 1 below, source: Goldman Sachs).

Figure 1: COMEX Gold Net Speculative Position (Left, million toz) vs. 10-year TIPS Yield (right, inverted)

COMEXGOLDSPECSWe believe the trend for gold prices thus remains down. This is further compounded by short-term, but significant global deflationary forces, some of which we have previously discussed.

Those that are Gold Miners Specific

All extremes eventually become their opposites.” – Plato, and later Carl Jung

A bull market inevitably builds excess, and nowhere is this more evident than in the evolving marginal cost curve of gold miners. At the bottom in 2002, the marginal cost of extraction was approximately $300 a troy ounce. Despite technology improvements, the marginal cost of extraction steadily rose to nearly $1,000 an ounce by 2011 as gold miners exploited lower-grade mines and as mine workers enjoyed higher wages. Since the peak in 2011, the marginal cost of extraction has come back down to $850 an ounce (see Figure 2 below, courtesy Goldman Sachs). Deflation has set in within the gold mining industry–and given that it is a commodity industry, it is a race to the bottom. Ironically, some gold miners are producing even more gold in an attempt to stem cash flow problems–thus increasing supply and depressing gold prices even as demand remains anemic. So far, there have been no major mine closures; nor major bankruptcies in the industry. We believe that neither the price of gold nor gold mining stocks will bottom until the industry experiences a couple of major mine closures and/or bankruptcies. The gold mining ETFs, GDX ($24.26) and GDXJ ($36.66), could easily decline another 25-30% from current levels.

Figure 2: Real Gold Prices vs. Marginal All-in-Sustaining Cost of Production vs. Marginal Cost of Extractionrealgoldprices

Those that are U.S.-centric

As we discussed in our March 30, 2014 commentary (“An Imminent Correction in Risk Assets“), the outlook for U.S. monetary policy is not conducive to higher prices for risk assets, including gold–at least not in the short-run. While the price of gold continued to rally for three more months after the end of QE2 (peaking in September 2011)–gold has failed to rally despite the implementation of QE3 (which resulted in $1.5 trillion of agency MBS and Treasury purchases). As QE3 is scheduled to end by the October 28-29 FOMC meeting, it is likely that the price of gold will be pressured even further, unless: 1) U.S. commercial banks overcome their regulatory burdens and start lending more freely, or 2) the Euro Zone threatens to fall apart and the ECB is forced to monetize a substantial amount of peripheral debt and/or Euro ABS securities. Note the chances of either of these scenarios occurring are next to none (Spanish 10-year yield is trading at just 3.18%, or 50 bps above the 10-year Treasury).

With regards to the U.S. short-term inflationary outlook, the two following indicators (one leading and one coincident) come to mind:

1) The highly respected ECRI’s monthly U.S. Future Inflation Gauge (a leading indicator) remains depressed. For example, the rise in U.S. home prices (owners’ equivalent rent makes up approximately 25% of the U.S. CPI) has recently stalled due to anemic growth in U.S. wages and the rise in U.S. interest and mortgage rates. Unless U.S. wages experience a structural uptrend (not likely anytime soon), CPI inflation will likely remain low. Note that one of the best predictors for future CPI readings is actually today’s CPI reading, as the CPI reading is fed into variables that could cause future inflation, such as Social Security cost-of-living adjustments, union wage adjustments, and some private defined benefits pension plan cost-of-living adjustments.

2) The Cleveland Fed’s expected inflation yield curve as imputed from TIPS yields is still low, despite the Fed’s purchases of $4 trillion of agency debt, agency MBS, and Treasury securities over the last five years (see below chart). As of March 2014, the ten-year expected inflation rate is 1.74%. With the Fed beginning to shift to a tightening mode, we expect the Fed to begin raising the Fed Funds rate by the middle of next year, and for U.S. real interest rates to be definitively positive by the end of 2015.

While we are bullish on gold prices over the next 5-10 years (due to what we believe will be heightened political will to inflate out of our future pension/healthcare and student debt obligations), the next 6-12 months remain a very bearish period for gold prices.

clevelandfedcpi

Those that are Global in Nature

1) The annual growth rate of foreign reserves on the Fed’s balance sheet–an important global liquidity indicator–turned negative earlier this year–the first time since early 2012. Global deflationary events beginning in the 1980s (1994 Tequila Crisis, 1997 Asian Crisis, 1998 Russian/Brazilian/LTCM crises, etc.) have always been preceded by a year-over-year decline in the amount of foreign reserves on the Fed’s balance sheet. This is not surprising, as the vast majority of global trade is still settled in the US$. As the U.S. current account deficit shrinks (due to higher domestic oil production, “on-shoring” of U.S. manufacturing, etc.) global US$ liquidity will continue to decline–putting further pressure on the balance sheets of countries that are dependent on exports to the U.S. Since many of these countries are net purchases of gold, we believe declining foreign reserves will act as a deflationary force for gold prices over the next 6 months;

2) On April 1, Japan raised its sales tax from 5% to 8%. This act–which is felt instantaneously–is deflationary for the Japanese economy. The Bank of Japan is now expected to ramp up its quantitative easing policy (which will take several quarters). Domestically, this will counteract the deflationary effects of the sales tax increase by exporting deflation around the world. This deflationary shock will be felt mostly by Japan’s trading partners, as well as its trade competitors (South Korea, China, etc.). Since China is traditionally the second largest net buyer of gold, we expect Chinese demand for gold (whether as an investment or inflation hedge) to subsequently decline. In addition, while the Japanese economy will experience some inflation due to the Bank of Japan’s actions, this will have little effect on gold as Japanese demand for gold is effectively zero (most likely, the Japanese will purchase domestic equities/real estate as an inflation hedge).

3) India’s official gold imports hit a peak of 162 tonnes in May 2013. Indian gold imports made up 28% of the world’s demand in 2012–ahead of Chinese gold imports at 26% of the world’s demand. At the peak, gold imports were the biggest contributor to the Indian current account deficit. Since the Indian government took more proactive steps to curb gold demand in summer 2013, official gold imports have dropped substantially (see Figure 3 below, courtesy Goldman Sachs). Official Indian gold imports (which excludes imports via smuggling channels) are expected to be only 550 tonnes or lower in 2014–down from as high as 863 tonnes in 2012. The raising of gold import tariffs has resulted in a two-thirds reduction of the Indian trade deficit since May 2013! We do not believe the Indian government will reduce the import tariff substantially over the next 6 months. As such, Indian public policy suggests an ongoing deflationary pressure on both Indian gold demand and gold prices in general.

Figure 3: India’s Gold Imports have Collapsed Due to Higher Import Tariffs

indiangoldimports

 

An Imminent Correction in Risk Assets

In our 2014 U.S. stock market outlook (published on December 22, 2013), we asserted that U.S. stocks will only return in the single-digits in 2014, due to: 1) a tightening Fed, 2) the reluctance of the ECB to adopt quantitative easing policies, 3) higher-than-average valuations, as well as 4) increasingly high levels of investor speculation (e.g. record high levels in margin debt outstanding). We stand by our 2014 S&P 500 year-end target level of 1,900 to 2,000.

Conversations with our clients suggest one overarching investment concern/theme. Investors are concerned with the unprecedented global monetary experiments, while most of Asia is concerned about runaway Chinese credit growth and the country’s shadow banking system. The shift from a unipolar investment environment (one dominated by U.S. policy and institutions) into a multipolar one–beginning with the fall of the Berlin Wall in 1989 and accelerating with China’s entry into the WTO in 2001–means an understanding of global macro is essential to understanding the main drivers of future asset prices (hint: it is not classical indicators such as P/B, P/E ratios, etc.). Going forward, monitoring the actions of the People’s Bank of China and Chinese credit growth will be just as important as monitoring the actions of the Federal Reserve.

We believe 2014 represents a transition year as the Federal Reserve definitively halts its QE policies/asset purchases and as Chinese policymakers adopt financial reforms (e.g. allowing companies to go bankrupt to prevent future moral hazard problems) in an attempt to alleviate investors’ long-term concerns. In many ways, these recent moves–including Fed Chair Janet Yellen’s surprisingly hawkish comments at the March 18-19 FOMC meeting–are reminiscent to the events of 1994, when the Greenspan-led Fed unexpectedly began hiking the Fed Funds rate in February 1994. The Fed Funds rate rose from 3.0% to 5.5% by the end of the year, while the two-year Treasury yield surged from 4.0% to more than 7.5%. The S&P 500 experienced significant volatility and finished down the year by 1.5%.

We do not believe the Fed will hike the Fed Funds rate anytime soon; however, we anticipate the Fed to halt its QE/asset purchase policies by the end of this year; and to begin hiking rates in the 1st half of 2015. That is, global liquidity will get tighter as the year progresses–further compounded by overbearing U.S. financial regulations, a hike in the Japanese sales tax this week from 5% to 8%, and the ECB’s reluctance to adopt a similar QE policy. The action in the S&P 500 in the 1st quarter of this year has so far proved out our thesis. The S&P 500 ended 2013 at 1,848.36 and as of last Friday, sits at just 1,857.62 for a meager 0.5% gain. We reiterate our year-end target of 1,900 to 2,000. In the meantime, we believe the S&P 500 is heading into a significant correction, i.e. 10-15% correction over the next 3-6 months–for the following 3 reasons.

1) Hot Money Action is Getting More Risk-Averse

Since the global financial crisis ended in early 2009, EM fund flows from DM countries have been highly positive. Fund flows to EM countries turned negative during the summer of 2013. Many EM countries never implemented much-needed reforms during the last boom (Russia leadership just proved it is still stuck in the 19th century), nor made much-needed infrastructure and educational investments (with the major exception of China). Investors have forgotten that EM growth (actual and potential) rates no longer justify such investment fund flows–and have continued to dial back risk-taking in general. Most recently–the stock prices of two of the hottest industries, i.e. Big Data and Biotech–have taken a significant hit in recent trading. We believe momentum investors are now leaving the stock market; and that there is a good chance this will turn into a market rout (i.e. S&P decline of 10-15%) over the next 3-6 months.

2) The Federal Reserve’s Monetary Policy Tightening

Once the Federal Reserve wrapped up its “QE2″ policy of purchasing $600 billion in Treasuries at the end of June 2011, the S&P 500 subsequently corrected by 14% over the next three months. The S&P 500 had already declined by 3% during May/June 2011, as the Fed did not provide a clear indication of further easing (i.e. QE3) until later in 2012. Prior to the end of QE2, the Fed purchased an average of $17.5 billion of Treasuries on a weekly basis. At the peak of QE3 (i.e. before the recent tapering), the Fed was purchasing an average of $20.0 billion of Treasuries and agency-backed mortgage securities on a weekly basis. The current tapering process is already having an effect on global liquidity, as foreign reserves held by global central banks have been declining over the last couple of months. Based on the current tapering schedule, the Fed will halt its QE policies at the October 28-29, 2014 FOMC meeting. The Fed’s balance sheet of $4 trillion of securities will take a decade to unwind (if ever). Unless the ECB chooses to adopt similar QE policies, we believe global central bank tightening (EM central banks are projected to tighten further over the next six months) will act as a significant headwind to equities and other risk assets for the rest of 2014.

Feds Balance Sheet

 3) A Record High in U.S. Margin Debt Outstanding

Our studies and real-time experience indicate significant correlation between U.S. margin debt outstanding and other leverage indicators, as well as major peaks and troughs in the U.S. stock market. We first discussed this indicator in our January 29, 2014 commentary (“Record Rise in Margin Debt Outstanding = Single-Digit U.S. Stock Returns in 2014“). We asserted that the record rise in margin debt outstanding (a 12-month rise not seen since July 2007–during the last major peak in stock prices) is indicative of significant speculation in U.S. equities. Since our January 29 commentary, U.S. margin debt outstanding has risen another $23.6 billion to a record high $502 billion. Meanwhile, the 6-month rise in margin debt outstanding hit $88 billion–again, a high not seen since July 2007 (when it hit $105 billion). More important, it is clear to us–based on the action in Big Data and biotech stocks over the last couple of weeks–that the willingness to speculate is declining. All of these indicators suggest to us that the S&P 500 will experience a major 10-15% correction over the next 3-6 months. We also assert that Emerging Market stocks will experience a significant decline, along with gold prices. We expect gold prices to bottom at the $1,000 to $1,200 an ounce level over the next 3-6 months. We will look for a buying opportunity in both gold and North American gold-mining stocks sometime in the next two quarters.
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Building a Specialty Brand in the 21st Century

Here at CB Capital, we are a firm believer in working with strong consumer brands. Our investors like them, and understand how to analyze, cultivate, and assist brands in staying at the forefront of various consumer and societal trends.

For our brand clients, we understand that your consumer brand wants loyal, sophisticated, and high-margin consumers. These sophisticated consumers must have purpose, and your brand must fit their purpose or what they stand for, whether it is a lifestyle option (Whole Foods, Nike, Starbucks, etc.), part of an overall movement/statement (Tesla, Apple, etc.), part of a niche culture (Lululemon, Urban Outfitters, Burton, Active Ride Shop, etc.) or recognized as the best in class (Amazon, Google, Goldman Sachs, etc.). Once your brand becomes part of your consumers’ lives, it is sticky. Your brand will ride the waves of their successes. Marketing becomes word-of-mouth, and your products will sell at a premium.

On the other hand, you do not want fickle or gullible consumers. Most of these folks have no solid belief systems and cannot be trusted to be long-term, loyal consumers. These consumers are not only fickle, but will only dilute your brand. Sophisticated, generous, and loyal consumers would not be wearing or consuming the same brand as these folks. Many of these folks also do not play fair—returning items to stores they have worn for a night, etc. True, sophisticated and responsible consumers/citizens do not engage in this type of practices.

As an aside, there are certain sub-industries and industries where there still exist numerous brand-building opportunities. The fast casual, healthy and organic restaurant industry in the U.S. comes to mind, as well as lifestyle brands that serve various niche consumers–we believe that brands catering to anti-establishment, individualistic but responsible ideas will continue to garner a premium in the 21st century. For other industries, it is mostly a race to the bottom. These include traditional/mass retailing, the PC/server industry, as well as traditional full-service and casual dining chains.

To create and manage a brand successfully, we must understand that a brand name is part reputation, part familiarity, part psychology, and we must also understand the unquantifiable thrills or sense of belonging that a consumer feels when he or she purchases something that bears his or her favorite brand name. The concept of a brand name first arose with the advent of advertising and mass media in the 1930s—further compounded by the adoption of the 40-hour workweek, allowing consumers more time to enjoy the things that they bought. It is not a coincidence that Disney’s success took off during the 1930s, as for the first time, the middle class had idle time to watch films. To this end, Interbrand’s ten factors of creating and managing a brand are timeless. The information in the below figure are taken verbatim from Interbrand.

Figure 1: Interbrand’s Ten Timeless Factors for Managing/Valuing Brands

Internal Factors

External Factors

Clarity: Clarify internally about what the brand stands for in terms of its values, positioning and proposition. Clarity too about target audiences, customer insights and drivers. Because much hinges on this, it is vital that these are articulated internally and shared across the organization. Authenticity: The brand is soundly based on an internal truth and capability. It has a defined heritage and a well-grounded value set. It can deliver against the (high) expectations that customers have of it.
Commitment: Internal commitment to brand, and a belief internally in the importance of brand. The extent to which the brand receives support in terms of time, influence, and investment. Relevance: The fit with customer/consumer needs, desires, and decision criteria across all relevant demographics and geographies.
Protection: How secure the brand is across a number of dimensions: legal protection, propriety ingredients or design, scale or geographical spread. Differentiation: The degree to which customers/consumers perceive the brand to have a differentiated positioning distinctive from the competition.
Responsiveness: The ability to respond to market changes, challenges and opportunities. The brand should have a sense of leadership internally and a desire and ability to constantly evolve and renew itself. Consistency: The degree to which a brand is experienced without fail across all touchpoints or formats.
  Presence: The degree to which a brand feels omnipresent and is talked about positively by consumers, customers and opinion formers in both traditional and social media.
  Understanding: The brand is not only recognized by customers, but there is also an in-depth knowledge and understanding of its distinctive qualities and characteristics. (Where relevant, this will extend to consumer understanding of the company that owns the brand).

Building a Strong, Trustworthy Brand in an Age of Low Corporate Trust

London Business School Professor Daniel Goldstein remarked in a March 2007 (pre- financial crisis) Harvard Business Review article that “Research shows that customers may prefer a recognized brand even if it has clear shortcomings—even if, in certain circumstances, it’s dangerous. Consumers in a recent study believed that airlines whose names they recognized were safer than unrecognized carries. On the whole, this belief persisted even after participants learned that the known airlines had poor reputations, poor safety records, and were based in undeveloped countries. In other words, a lack of recognition was more powerful than three simultaneous risk factors.That was the pre-financial crisis point of view—when trust in corporate brands, corporate leaders, and mainstream advertising was still high.

Although already declining, consumers’ trust (especially the sophisticated and potentially loyal consumers that every specialty brand wants) took a nosedive as the financial crisis accelerated in 2008. Americans suddenly realized there was a dearth in global leadership, in all levels of society. Your financial adviser failed you. Professors did not predict the downturn. American consumers no longer trusted mainstream brands and traditional marketing/advertising campaigns. Americans initially cut back on spending; then became more selective as the U.S. economy recovered (many industries, such as the casual dining industry, are having a difficult time responding to this). Brands responded to the economic crisis by running for cover (the weaker brands went out of business), by first attacking its supply chain (i.e. cutting costs) and laying off workers. While this helped profit margins in the short-term, this is the wrong strategy in the long term. During recessionary times—and with Americans becoming more selective in their spending—the competition for sophisticated and loyal consumers becomes even more intense. Combined with the growing distrust in mainstream brands and advertising, Brands will need to find better ways to engage and respond to its consumers’ ever-more selective needs and high standards.

How do you build brand value in an age of low corporate trust, and among an unprecedented increase in marketing channels?  As early as 2010, Eric Schmidt remarked that every two days, the world created as much information as we did from the dawn of civilization up until 2003. Naturally, traditional (TV, newspaper, etc.) advertising is dead, especially among sophisticated, younger consumers who are also selective in their consumption of media. It is not surprising that Forrester Research sees 1) social media, and 2) mobile marketing, as the two most promising marketing spend categories  over the next several years:

Figure 2: U.S. Interactive Marketing Spend Forecast (source: Forrester Research, Inc.)

forrester interactive marketing

The rise of social media not only changes how we communicate; but how Brands could communicate to their consumers. The most effective manner for Brands to engage their consumers—and to build brand value—is no longer B2C (i.e. Business-to-Consumer, or one-to-many). Most of our clients no longer believe in this marketing model. Rather, our research have found that social media is—for the first time—empowering many “influential” consumers who could be strong advocates for their favorite brands. For the first time, the rise of Big Data and easy-to-use collaborative tools allow consumers to engage in more dynamic, one-on-one interactions. The key for Brands is to gather and then harness the power of their most influential consumers to promote awareness and help close sales.

In other words, Brands first transmit their message to their most influential and dynamic consumers, who also provide active feedback to their most-loved brands. From hereon, the Brand begins to lose control of the messaging, as much of that process is now dependent on its influencers.

Figure 3: Key to Brand Building in the 21st Century (Source: CB Capital Partners, Inc.)

21st century marketing

For certain Brands, losing some or all control of its messaging is a scary thought, especially in today’s age of “viral” campaigns and consumer activism. But it is precisely because of this latent power in consumer (influencers’) activism, aided by social media technologies, that injects such power into today’s market campaigns—all at very little cost. An extreme sample is what we have labeled as the “Veronica Mars Model,” where through the power of modern social media marketing and fund-raising, the ROC of a project could literally hit infinity (covered in a recent blog post). This new way of marketing is all the more effective because it keeps Brands actively engaged with their influencers and thus keep them on their toes.

Building a Strong, Trustworthy Brand in a Globalized, Self-Actualizing World

Segmentation, especially for specialty brands, is an important and delicate exercise. Done correctly, your Brand will thrive. Done incorrectly, it is a waste of marketing dollars at best. We learned in Marketing 101 that segmentation based on demographics (income, education levels, etc.) no longer works (the major exceptions are certain film genres and the video gaming industry). Demographics data is easy to gather, and in the by-gone “Mad Men” era, high-income/education, nuclear families may have aspired to similar material brands, but this is no longer the case. We like to describe the evolution of consumers’ needs—on a global basis—using a modified version of Maslow’s Hierarchy of Needs, overlaid with a time line showing the impact of globalization on consumer trends since the end of WWII.

evolution of consumer decision making

We can be forgiven for citing Maslow’s Hierarchy of Needs, since we live and work in southern California. With the evolution of the consumer decision-making process, it no longer makes sense for a Brand to segment and target its market using demographics when its potential market is global, and when individuals no longer identify with their fellow citizens. For example, I teach an upper-division public policy class at UCLA. My U.S. students are very culturally aware and most of them identify themselves more closely with other global, young, and well-educated citizens—not with their fellow Americans. Repeatedly, CB Capital’s experience with our clients and our research show that:

1) Traditional segmentation and marketing methods no longer work. Clients who adopt social media and community outreach efforts wisely have been very successful, while keeping marketing costs low. For years, one of our clients has developed residential communities through feedback from focus groups and local surveys, versus traditional demographic methods. Through unique designs catering to the needs/tastes gathered from this feedback, our client is able to sell his homes for a premium, while keeping construction costs relatively low. His communities are integrated into nature, and are aesthetically pleasant. On a recent visit, we met a young family, older and younger couples, and large social groups. Clients who do not understand this evolution still embrace traditional advertising, which has no feedback loop, while outcomes cannot be measured.

2) Consumer spending in the 20th century was driven mostly by material needs. Aspirational spending meant paying for “expensive” brands which provided a sense of belonging to the Bourgeoisie. Such consumer mentality still exists in China and India  today (where a Starbucks coffee, an iPhone, or a VW means you have “arrived”) but are slowly becoming passe. Today–as the above figure reminds us–premium consumer brands are based on the concepts of self-identification, self-actualization, along with a sense of belonging within a group of like-minded, distinct individuals with similar life philosophies.

The successful 21st century brand will need to understand and adopt the marketing concepts and consumer trends as enunciated by points 1) and 2) above. Otherwise, it is simply a race to the bottom, as many 20th century “brands” and concepts are fast becoming commoditized.  In the latter case, “brand building” will be a waste of money. We are mindful of these facts and strive to only work with clients with strong, defensible, 21st century brands.

The Robot Revolution Invades U.S. Casual Dining

In my July 15, 2007 commentary, we foresaw the potential for a dislocation in the U.S. casual dining industry through technological innovation and adoption. At the time, the iPad did not yet exist; but technologies such as touchscreen, high-speed WiFi, and the necessary software systems for automation were beginning to form. At the time, we believe the appearance of Microsoft’s “Surface” technology will herald a trend of full-blown automation in the casual dining industry. Quoting our July 15, 2007 commentary:

For a “dislocation” technology in the restaurant industry, look no further than the Microsoft “Surface” technology – which is simply an amazing piece of technology.  At first glance, kids will simply think of this as a cool technology to view photos or transfer videos, but give it a couple of years and many restaurants will start utilizing this technology as part of their food/drink ordering and clean-up system.  Besides having the ability to order food or drinks, the “Surface” will know what you are drinking and will ask you if you need a refill when your cup is half-empty.  Once all your plates are empty or nearly empty, the “Surface” will also alert the busboy so he can come and remove your dishes.  At the same time, you will be able to start ordering desserts as well, or of course, pay for your meal (either through your credit card or through Paypal).  In five years, the number of waiters needed in the restaurant industry will be halved, and 15% tips will no longer be needed (assuming a reasonable 40% decline in cost each year, these US$10,000 machines/surfaces will only cost US$750 by the end of 2012).  What outsourcing or off-shoring cannot do (i.e. displace workers whose jobs tend to be localized), technology will.

We were a little early as we assumed adoption would begin by 2009-10. At the time, we did not foresee the severity of the 2008-09 financial crisis. With the over-expansion of many casual dining chains during 2004-06–and with liquidity, borrowing, and consumer spending suffering a major breakdown during the 2008-08 financial crisis–many casual diners simply stopped investing in new stores and technologies. Now that U.S. consumer discretionary spending is back to a 6-year high (and with stock prices of many casual diners, such as EAT, DIN, and CAKE, near all-time highs), investing in new technologies to streamline the ordering and payment process suddenly makes sense again.

For many casual dining chains, there are little points of differentiation among their brands. e.g. Olive Garden, T.G.I. Friday’s, Ruby Tuesday, etc. As we discussed in our May 26, 2013 commentary (“The Generational Divide in Casual Dining Trends“), many traditional, casual dining chains also suffer from three major strikes–at least among the Gen-Ys: 1) A perception of a lack of quality service, 2) A perception of serving cheap-quality food, and 3) An outdated décor. These three strikes are especially glaring when compared to the newer, healthier, and more convenient choices such as Panera Bread, Corner Bakery, or at the higher end of the scale, Cheesecake Factory, RockSugar, and of course, independent operators–especially those with high-end brand names or those serving more exotic (e.g. sushi) and adventurous cuisines. Simply put, what the Gen-Ys settled for when they were kids would not work today.

Seen in this context, there is not much many casual dining chains could do to differentiate their products to increase profit margins–major strategic or product offering shifts notwithstanding. The only option is cost-cutting through technology–in this case, automation technology that streamlines the ordering and payment processes.

Most appropriately, Austen Mulinder, CEO of Ziosk and a former Microsoft executive, is now implementing the idea of tabletop tablets to the casual dining industry. Ziosk’s goal is to “revolutionize the experience and economics of Casual Dining,” and claims that over 100 million guests have already been served under its system. Most notably, Ziosk recently won a national contract to provide tabletop tablets to Chili’s, which will likely accelerate adoption by other national chains.

Exhibit 1: Ziosk Tablet – Order, Pay, and Play Loyalty-Related Games at the Table

Ziosk tablet

Out of the current installation base of over 1,200 locations, Ziosk claims that 80% of customers interact with the device in one way or another. The most frequent use is for direct credit card payment, the 2nd for survey questionnaires, and the 3rd for ordering of drinks, desserts, and appetizers. Ziosk claims that dessert sales are 20% to 30% higher for those who use the device, with quicker table turns and increases in chain loyalty if guests opt for email signup. All in all, restaurants that choose to utilize this device tend to experience 3% higher core food and drink sales on average.

One of Ziosk’s major pitches for this device is that the cost is “less than free,” as the cost of these devices could be subsidized by gaming revenue generated on these devices. A final area of benefit is reduced labor intensity, assuming more customers choose to order and pay through these devices. While restaurants deny that these devices will replace waiters, we believe this is where the casual dining industry is heading. e.g. Some Tokyo restaurants are already doing away with waiters. Make no mistake: The robot revolution has now spread to the casual dining industry.

Exhibit 2: California, Texas and Florida are the Focus Expansion Areas in 2014

Ziosk locations

Declining U.S. Dollar Liquidity Coming Home to Roost for Emerging Markets

Emerging Markets’ finance ministers today surely feel the pain of their European counterparts in the early 1970s. Shortly after President Nixon removed all U.S. dollar convertibility to gold, European finance ministers complained of the global inflationary pressures of such a move, driven by Nixon’s “guns and butter” policy and a deteriorating current account deficit. In just a generation, the United States transformed from the world’s largest creditor to the largest debtor country. Nonetheless, the superiority of the U.S. Dollar as the world’s reserve currency was never really challenged. Surely, Charles de Gaulle–who tried to tip our hand by trading France’s dollar reserves for gold in 1963–must have been spinning in his grave.

Responding to his European counterparts, U.S. Treasury Secretary John Connally famously said “The dollar is our currency, but your problem.” All of which is true. Sure, I lived in Texas for 12 years. Many of the buildings at my alma mater, Rice University, were funded by the wealth of the oil barons–including that of Sid Richardson, whose ventures helped Connally become a successful businessman in the 1950s. This is typical Texan culture–John Connally was merely being blunt–this has been the official if unspoken policy of the United States since Alexander Hamilton helped establish the First Bank of the United States in 1791.

The QE policies created by outgoing Fed Chairman Ben Bernanke simply continues this tradition of “America first; the rest of the world second.” Even the misguided Fed policies of the early 1930s was no exception. As all former and future Federal Reserve Chairs recognize, Fed policy must be targeted for the good of the U.S. economy and U.S. labor–not fine-tuned to satisfy the whims of finance ministers of foreign countries.  Making policy for the good of the U.S. economy–and the U.S. economy only–is the only way to ensure the superiority of the U.S. Dollar as the world’s reserve currency.

Seen in this light, the current plight of EM countries (e.g. Turkey, South Africa, Brazil, and Russia) is not really a problem for U.S. policymakers, even though U.S. “hot money inflows” have overly inflated EM currencies and assets in recent years. But make no mistake: U.S. Fed tapering, as well as a shrinking U.S. current account deficit  (an expanding U.S. current account deficit acts as a global liquidity provider, as most of world trade is still denominated in US$), will continue to be a drag on EM countries for much of 2014. The fact that recent rate hikes by Turkey, South Africa, Brazil, and Russia failed to stem fund outflows is highly problematic (in Russia’s case, it is especially troubling as Brent Crude is still over $100 a barrel). Cumulative EM net fund flows since January 2013 turned negative last August (below chart courtesy the Bank of England), and we believe fund outflows from EM countries will accelerate as the Fed continues to taper. Other global liquidity providers that are strong enough to arrest this decline–i.e. China and the U.S. consumer–will simply not come to the aid of EM countries. The only possible candidate is ECB easing, but we do not anticipate the ECB to ease aggressively enough to stem the decline in global liquidity.

Chart 1: 2013 Cumulative Net Fund Flows into EM Countries Turned Negative Earlier Last Summer

EMvsDMfundflows

More important, the state of EM finances has been declining precipitously over the last several years. Studies from the BIS and the Bank of England show that over the last several years, large foreign inflows into EM countries have enabled EM credit levels to rise sharply. As such, credit-to-GDP gaps in most EM economies have risen to levels not seen since the 1997 Asian Crisis, as shown below. With EM outflows now accelerating–and with the Chinese and other EM economies experiencing dramatic slowdowns–I expect EM assets to underperform for at least the next several months. Furthermore, recent corruption scandals in Turkey are reminding investors that political risks in these countries is still quite high. There may be a buying opportunity in EM equities during Q2 or Q3 2014, but for now, stay away.

Chart 2: Credit-to-GDP Gap in EM Economies – Higher than that During the 1997 Asian Crisis

credit-to-GDP-gaps-EM

Record Rise in Margin Debt Outstanding = Single-Digit U.S. Stock Returns in 2014

In a May 24, 2007 commentary titled “Leverage, Leverage, and more Leverage” (four months before the peak of the last bull market), I emphatically stated: “Despite what the mainstream media says, there are now signs that liquidity conditions are deteriorating … Make no mistake: This “pillar” of liquidity [subprime lending] of the U.S. housing market has fallen and will have a depressing effect on the U.S. housing market and on U.S. households’ liquidity for many years to come.

By early October 2007, I was discussing why I was short the U.S. stock market and why investors should be trimming their equity long positions.

We believe there are 3 distinct pillars to superior investment performance: 1) Investing in non-correlated strategies (e.g. Japanese stocks in the 1960s and 1970s), 2) the ability to find inefficiencies in selected markets (e.g. private real estate or the ability to influence markets, such as that of PIMCO), and 3) recognizing shifts in investment regimes ahead of the curve, and adjusting one’s asset allocation or investments accordingly.

If an investor or adviser has no ability to engage in 1), 2), or 3), then he or she should leave the industry and do something else. This certainly applies to most advisers and investment managers I have met.

But I digress. Back in May 2007, we recognize that there existed unprecedented leverage in the global financial system–and more important, the availability and ability to pile leverage on leverage was drying up. The desire to speculate using immense leverage was not limited to the subprime or LBO markets. Consider that Japanese households were actively engaged in the Yen carry trade, with margin currency trading increasing by 41% to US$896 billion in the Japanese retail market during 1Q 2007 alone. In fact, Japanese individuals were responsible for as much as 30% of all FOREX trading in the Tokyo time zone by early 2007.

Another leverage indicator was U.S. margin debt outstanding. We like to use this age-old, proven benchmark to measure the amount of speculation in the U.S. stock market. While we recognize that both institutions and high net worth individuals can gain access to leverage through futures or OTC swaps, the amount of U.S. margin debt outstanding is much more transparent and is reported monthly. More important, the rate of change in U.S. margin debt outstanding has had significant correlation to other leverage indicators, as well as major peaks and troughs in the U.S. stock market.

For example, in the same May 24, 2007 commentary, we mentioned that the six-month increase in margin debt ($74 billion) had risen to its highest level since March 2000, while the 12-month increase ($77 billion) rose to its highest level since September 2000. We also mentioned that the 12-month increase in margin debt for month-end May 2007 would rise again. In fact, margin debt outstanding rose by $40.2 billion for the month of May 2007 alone. The 12-month increase in margin debt outstanding would eventually surge to a record high of $160 billion by the end of July 2007. At the time, we believed–at the very least–a significant correction was at hand.

Fast forward to today. Many of our stock market indicators are overbought (see our January 10, 2014 commentary “The Message of the CB Capital Global Overbought-Oversold Model“). In our December 22, 2013 commentary (“CB Capital’s 2014 U.S. Stock Market Outlook: Cautious and Moderately Bullish“), we asserted that U.S. stocks in 2014 will return in the single-digits, i.e. 5% to 10%. Furthermore, the latest margin debt numbers (as of December 31, 2013) also suggest of a highly overbought U.S. stock market, as evident in the below chart. In fact, the 12-month increase in margin debt has risen to $123 billion–the highest level since July 2007, and certainly the highest level since the current bull market began in March 2009. Seen in this context, even a single-digit return outlook in U.S. equities in 2014 could be construed as being too optimistic.

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The Message of the CB Capital Global Overbought-Oversold Model

I hope all our clients are off to a great start this year. If we could summarize our long-term global outlook in one word, it’d be “transformation.” e.g. Most U.S. college students are being forced to re-evaluate their life options, as 1) a university degree is no longer a ticket to sure-and-life-time employment, and 2) rising tuition costs mean opportunity costs of attending college (versus entering a trade) have become cost-prohibitive for many Middle Class Americans. A constant debate at CB Capital has been whether the rise of the American Middle Class in the mid-20th century was an anomaly–or if, more likely (in my opinion)–we are seeing the rise in the Global Middle Class, and that the American Middle Class is meeting them half-way.

Another structural force that is putting pressure on the wages of the Global Middle Class is the rise of “Smart Machines.” A decade ago, it was still too expensive to automate most tasks–even repetitive tasks with the exception of auto manufacturing and semiconductor production. In many ways, increasing automation over the last decade was simply an extension of a trend in place since the dawn of the Industrial Revolution in the late 1700s, i.e. automate simple, repetitive tasks through more capital intensive processes. The rise of Smart Machines is now altering the fundamental fabric of working labor, especially among Emerging Market Countries. In the past, upstart EM countries were able to industrialize (e.g. China in the 1980s to 2000s) by taking advantage of their low-cost labor and a significant export market. The rise of lower-cost, Smart Machines will put an end to this, as we will discuss in our 2014 inaugural global macro issue.

“Transformation” and structural trends notwithstanding, we are also big believers in “reversion-to-the-mean” trades. At the same time, we believe in the increasing evolution of the global human condition, so we (for the most part) don’t believe in shorting overvalued markets as measured by traditional benchmarks such as P/E or P/B ratios. We do, however, like to go long in distressed or oversold opportunities, as long as the long-term economics make sense.

Our global macro commentaries have always been more tactical and granular. We have discussed individual commodities, as well as certain conditions in specific countries, such as China and India. For most of our clients, we realize it is very difficult to keep track of all country-specific market indices and new international ETF products. To that end, we have constructed a simple model designed to keep track of the overbought/oversold conditions in all Developed and EM investable countries and regions as tracked by the MSCI indices.

The inner workings of the CB Capital Global Overbought-Oversold Model are rather simplistic. For each country or region, we first compute the month-end percentage deviation from its 3-, 6-, 12-, 24-, and 36-month averages. Each of these percentage deviations are then ranked (on a percentile basis) against all their monthly deviations stretching back to December 1997 (May 2005 for the MSCI Frontier Market Index). This way, we are comparing apples to apples and can control for country- or region-specific volatility. Following is our Global Overbought-Oversold Model readings for the major indices and Developed Markets as of December 31, 2013.

Global Overbought Oversold Model Dec 2013 1

All the percentile rankings highlighted in red or green represent rankings: 1) in or below the 10th percentile, and 2) in or above the 90th percentile, respectively. That is, relative to the historical percentage deviations of the same country or region, a ranking highlighted in red is more oversold than 90% of its readings going back to December 1997; while a ranking highlighted in green is more overbought than 90% of its readings. For example, the world’s developed markets (MSCI World) is highly overbought on a two-year time frame, as its current price level’s deviation from the two-year average is higher than 94.2% of all historical deviations going back to December 1997. Similarly, the U.S. stock market is now highly overbought on a two- and three-year time frame. This is one reason why–as discussed in our 2014 U.S. Stock Market Outlook–we are more cautious on U.S. stocks this year, even though we do not foresee a peak in U.S. equity prices anytime soon.

Note that Emerging Markets is only mildly oversold on all time frames. Such readings do not guarantee above-average returns this year, especially with challenging fundamentals such as social conflicts and deteriorating trade deficits (e.g. India, Indonesia and Brazil). Following is our Global Overbought-Oversold Model readings for Emerging Markets as of December 31, 2013.

Global Overbought Oversold Model December 2013 2

Despite the recent selling in Thailand and Turkey, none of the readings for EM countries are sufficiently oversold to warrant even a speculative trade on the long side. When it comes to reversion-to-the-mean trades, investors better make sure the underlying story has not changed–or else, an oversold condition could turn into a market crash (e.g. purchasing Japanese stocks during WWII, Asian bank stocks in 1997, or money-losing U.S. tech stocks in 2001). At this point, Thailand is only oversold on a 3-month time frame; its longer term readings are not attractive enough to warrant a long position, given the country’s current societal conflicts and political uncertainty. A much better trade would have been going long on the MSCI Germany (could be readily purchased through the MSCI German ETF) in December 2011, when the index was highly oversold on both a 3- and 12-month time frame. A long position taken on the MSCI German ETF at the end of December 2011 would have returned 32.1% in the next 12 months–far outpacing a long position in Developed Markets (MSCI World: +16.5%) and the U.S. (MSCI U.S.: +16.1%).

Again, note that the above model is a price-only model and therefore doesn’t take into account valuations. As has been emphasized, it also does not work well for countries that are experiencing secular changes, or for timing peaks in the stock market (the quickest way to lose money is shorting a market or a stock that has high positive momentum and/or high valuations). One thing that comes in very handy, however, is the model’s ability to evaluate oversold countries/regions and to provide initial ideas on the long side. Going forward, we will update this as appropriate for our clients.

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