Here is a question to begin this Friday’s Daily Reckoning: can there be financial stability in Europe if the assets of Europe’s banks are the liabilities of Europe’s governments and some of Europe’s governments are going broke?
We’ll get back to that question a bit later. But warming to today’s task, we’ll look at the mega-rally in U.S. stocks overnight and the big fight back/smack down by the leader of the nation’s bureaucratic class.
But first, there’s nothing like the smell of a short-squeeze in the morning, is there? Slipstream Trader Murray Dawes was calling for it all week. And he was busy getting into trades to profit from it should it arrive. Overnight it seems to have arrived with monster truck force.
The big blue chip Dow stocks were up 284 points, or 2.85%. But in the tech and small cap sectors, the gains were even bigger. For example, the Russel 2000 index of U.S. small cap stocks was up 4.34%.
That’s a good day’s work. It reminded us of the old adage that small caps tend to lead the market up when things are bullish and fall hardest when they are bearish. With that in mind, take a look at the chart below.
Australian Small-Cap Investigator editor Kris Sayce and your editor were talking about the advisability of making new recommendations in a market like this earlier in the week. Ultimately, along with Diggers and Drillers editor Alex Cowie, we decided that they ought to publish their best investment ideas regardless of the market. This means you focus on good companies – but you’re fully conscious the market you’re investing is dangerous.
Both Kris and Alex published their new recommendations last night. And according to the chart above, the timing could be good. Since mid-April Aussie stocks have fallen further and risen less fast than U.S. counterparts. The chart above includes Thursday’s U.S. trading session. But depending on how today’s session goes in Australia, that little green line at the bottom could be a lot higher.
Both Kris and Alex spent a lot of time in their respective reports talking about risk because there’ so much of it going around. You’ve got political risk in Europe. Geopolitical risk in North Korea. Sovereign risk here in Australia. And that’s all on top of the normal risk you take as a common stock investor in public companies engaged in enterprises with inherently unpredictable outcomes.
To be perfectly candid, with so many external forces whipsawing market prices, it is very difficult to be an investor in this market. It is more of a traders and speculators market. In our own newsletter, Australian Wealth Gameplan, we have a few core positions leveraged to a rising gold price and a falling Aussie dollar. Our value investing sleuth Greg Canavan pointed out earlier this week than in a market like this, the best strategy is to buy companies selling at a discount to book value to give yourself a margin of safety.
So, from the speculator to the bargain hunter to the generally risk averse (conscious of the possibility of the systemic collapse of leveraged global financial system), the market requires you to make a decision. Doing nothing is a decision, too. Yes, yes, it sounds post-modern, that inaction is a form of action. But in financial terms, being in cash because you prefer liquidity is a position too.
Our view is that the sense of relief over Europe’s sovereign risks is fundamentally stupid. Or ignorant. Or obtuse. Or wilful self-deception. The banks of Europe are stuffed with government debt. And when one man’s asset is another man’s liability, both parties are the poorer if the debtor cannot realistically repay.
His credits must be written down. His debts must be restructured. And the public balance sheet must be shrunk the same way private and non-financial corporate balance sheets have shrunk. Liquidate the bad investments and move on to a frontier of economic possibilities. That’s the future. For the present, we seem mired in the past.
“Whatever yardstick you care to choose,” writes Edmund Conway in the U.K.’s Telegraph, “share-price moves, the rates at which banks lend to each other, measures of volatility – we are now in a similar position to 2008. Europe’s problem is that the unfortunate game of pass-the-parcel came at just the wrong moment. It resulted in a hefty extra amount of debt being lumped on to its member states’ balance sheets when they were least-equipped to deal with it.”
So what if Europe’s problems haven’t really gone away? Does that mean rallies like this should be sold before the next leg of the Global Financial Crisis, where national governments really do default on their debt? And in the meantime, Europe’s panic attack has obscured very real structural problems in the U.S. and Chinese economies, both related to housing prices and the role they play with bank collateral.
Hmm. If it turns out the global balance sheet in the age of globalisation and securitisation was over-leveraged and debt-laden, then the next round of the GFC is going to make the first one look like a tea-party.
Not THAT kind of tea-party, although it’s fair to see that when a nation’s state finances collapse, the probability for social instability goes up a lot. Inflation and warfare are old bedfellows and campaigners. They know how to have a bad time.
Yet all of this might seem terribly far-fetched or unlikely to policy makers in Canberra and miners in Perth. The two continue to publicly quarrel in front of international capital markets to the detriment of Australia’s reputation as a safe destination for foreign investments. In order to save Australia, it was first necessary to castrate the mining industry.
Speaking to the Senate yesterday, Treasury Secretary Ken Henry knocked backed claims that the mining industry saved Australia from the worst of the GFC (which he apparently thinks is over). He said, “Suggestions that the Australian mining industry saved the Australian economy from recession are curious to say the least…. These statements are not supported by facts.”
We couldn’t find a quotation in which the Treasurer gave credit to Canberra for accounting for up to 60% of Australia’s exports in the last two years, by dollar value. But if he was referring to, say, the volume of words belched out by the government giving itself credit for being so smart, he’s probably right.
Really the most worrying words the Treasurer uttered, in our mind, were these: “Frankly, there is more than enough investment in train in the mining sector. The limit is access to labour and the capital needed to undertake the projects.” He was apparently responding to the claim that the new resource tax will lead to less investment, not more, as both he and the government claim.
The one factor in all this that Dr. Henry and the government seem to be leaving out is free will. Project decisions in the mining industry are not compulsory. The miners can’t walk away from projects that are already producing. This accounts for some of the fury over a tax that is retrospective.
But it’s as if the government believes many many mining projects will go ahead regardless of the policy…just because. As if the companies will stop making investment decisions based on the rate of return and the cost of the capital. They’ll just keep digging and drilling because that’s what they do, and if they don’t the government won’t have any profits to tax.
Beavers must dam. Fish gotta swim. Birds gotta fly. But miners don’t gotta mine in Australia.
In the real world of the private sector, decisions about what to produce are not determined by abstract public policy goals, which are themselves based on personal prejudices about the “appropriate” level of profit.
In the real word, final investment decisions are determined by what consumers want and whether a firm can deliver what the market wants at a profit. There is no requirement that Australia export iron ore or coal because it has them. If the miners can’t do it a profit that satisfies shareholders, they won’t do it at all, at least not here.
Perhaps that’s what the government wants in the end, to drive the mining companies from Australia, but not before confiscating as much revenue as possible. Perhaps the government wants the mining companies to hand back all their leases and turn the business of producing mineral wealth over to the people who really know how to do it: public servants and elected officials.
We’ll see how that works out. But it’s looking more and more like an international capital strike against Australia is a real possibility. For one, there’s a brewing credit crunch coming from an inevitable sovereign debt default in Europe.
Secondly, Australia’s public officials are looking anything but reasonable and sensible in the court of international capital market opinion. They are looking like grasping, blundering, bullying, but well-meaning dunderheads who have demonstrated a first-class ignorance of how wealth is created. The Rudd government has wanted to lead the world on a lot of issues. It’s well on its way.
Dan Denning
for The Daily Reckoning Australia
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