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The #1 Indicator that Predicted this Sub-prime Crisis is Flashing Red Again -- Overseas
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Wednesday, April 23, 2008 - Vol. 10, No. 97
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The #1 Indicator that Predicted this Sub-prime Crisis is Flashing Red Again -- Overseas
Today's comment is by Eric Roseman, Investment Director and editor of Commodity Trend Alert for The Sovereign Society.
Dear A-Letter Reader,
Back in 2006, most U.S. stocks were still hitting new all-time highs and credit markets were soaring on the heels of ultra-low borrowing costs. But at the time, one important leading indicator was still flashing red.
Nine months later, that same indicator correctly predicted a U.S. economic slowdown that morphed into the sub-prime mortgage monster by July 2007. What was the indicator? Bond yield inversion.
Historically, bond-yield inversion is an anomaly associated with an impending recession in the major industrialized economies. It occurs when short-term government bond yields trade higher than long-term interest rates. That usually suggests an economic recession or slowdown lies ahead.
More often than not, this indicator has accurately forecasted a U.S. recession in the post WW II period. And this indicator was right on the money predicting a bear market in U.S. stocks and credit starting last July.
What an Inverted Bond Yield Looks Like...
Starting in September 2006 until March 2007, benchmark two-year U.S. Treasury bonds started to yield more than respective 10-year Treasury bonds. That's a classic inverted yield curve where short rates yield more than longer term rates.
At the time, no one seemed to be concerned about it (except me). In fact, many pundits on Wall Street dismissed this bond anomaly as a short-term phenomenon. They said this it was driven mainly by foreigners buying up quality short-term U.S. Treasury paper and thereby reducing the available supply in the marketplace. But they were wrong.
The Father of Yield-Curve Inversion
Professor Campbell Harvey of Duke University was one of the first to point out the relationship between yield inversion and economic recession. He published his dissertation in 1988 in the Journal of Financial Economics. In 1989, he published a follow up article in the Financial Analysts Journal.
Harvey's prediction about the usefulness of the yield-curve was right on target. In 1991, after the 1990 recession, he noted that inversions of the yield-curve have preceded the last five U.S. recessions. That suggests the curve can accurately forecast the turning points of the business cycle.
Indeed, the yield-curve turned negative or inverted in late 2006 and successfully predicted the current U.S. economic slowdown. In some respects, the current slowdown has ballooned into the worst credit crisis since the Great Depression. I say that because not one, but several segments of the mortgage-backed market and other synthetic derivatives have clogged the financial system since last July.
Eight Countries Approaching or in
Actual Yield-Inversion
It's true that no in-depth analysis or research has been conducted on the universality of yield-curve inversion abroad. But recent evidence suggests that once it hits the United States - the world's largest credit market - it does spread to other industrialized economies.
As of mid-April, eight foreign markets are currently dogged by yield-curve inversion or approaching yield inversion.
Last year, the United Kingdom became the first G-7 economy after the United States to suffer yield-curve inversion for the better part of the year until last fall. For the record, the U.K. is now slowing sharply in 2008. Several British banks have come under pressure, one mortgage bank has failed and the housing market is unraveling.
Currently, six industrialized markets are mired in yield-curve inversion. These include Australia, New Zealand, Austria, Norway, Portugal and Switzerland. Two other markets now sport the same interest rates along the short and long end of the yield curve, including Denmark and Italy. This strongly suggests that an increasing number of mature economies are gradually being infected by America's sub-prime slowdown as interest rates narrow.
Historically, the Anglo-Saxon economies have typically followed similar economic cycles. Expansions or contractions in economic activity have been simultaneous events that happen within months of each another.
This was the case in 1989-1990 when the United States suffered a recession and the United Kingdom, Australia and New Zealand soon followed suit. In the early 1980s, all three countries suffered the same economic hardships as the United States following a period of surging interest rates and inflation in the late 1970s. The same was true for most developed economies.
Decoupling or Re-coupling?
In the late 2000s, analysts have been quick to surmise that emerging markets and other economies in Europe have finally decoupled from the U.S. economic cycle. Although the emerging markets have shown incredible resilience since last July when sub-prime first bombed credit markets, other major or mature economies have not been as fortunate.
It looks like the United Kingdom is heading into a recession or a severe slowdown. The country's credit markets have been bottled up for months, mortgages are turning sour and a leading mortgage bank collapsed last September (later rescued by The Bank of England).
British real estate is now contracting, especially in overheated London. The pound, though still relatively firm versus the beleaguered dollar, trades at an all-time low against the euro. The United Kingdom, in all likelihood, will join the United States and suffer a slowdown in 2008 or worse, a recession.
The majority of industrialized countries, including the European Union and Scandinavia, will increasingly share the same bond-yield inversion phenomenon that occurred in the United States 18 months ago. Over this period, benchmark 10-year Treasury yields have plummeted from 5.25% in late 2006 to 3.42% recently - a sizable gain for investors.
I expect yield-curve inversion and economic re-coupling to occur this year as the majority of mature economies suffer the same fate as the United States. Bond yields in Europe are poised to decline sharply despite the European Central Bank's (ECB) adamant stand against inflation.
With more Eurozone bond markets inverting, it's only a matter of time before central banks across the continent start hacking interest rates and the ECB abandons its inflation fight.
Bond-yield inversion is spreading. For European bond investors, this marks a good entry point to buy long-term government debt and investment-grade corporate paper ahead of a steeper yield curve by 2009 or 2010.
ERIC ROSEMAN, Investment Director
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Why 400,000 Americans Are Saying
"So Long" to the U.S. Part I
 A New York Times book reviewer writes this week:
"At a time when the Cassandras of finance are looking like realists, there is no gloomier prophet than Kevin Phillips. The author of 13 previous books including at least one classic, The Emerging Republican Majority (1969), Mr. Phillips sees a perfect economic storm coming. The final pages of his bleak new book, Bad Money, tell of an "unprecedented" number of Americans planning to leave the country or thinking about it. Readers of Bad Money may come away with a similar impulse to flee."
The fact Americans are fleeing is hardly news to our members and readers.
For the decade since our founding, we at The Sovereign Society have noted sadly that each year upwards of 400,000 U.S. citizens and resident aliens leave America to make a new home in some other nation. Admittedly, that number pales against the millions clamoring to get into the U.S., legally and otherwise.
But there's a huge difference in the economic status of these two groups.
Those seeking admissions (or just crossing our borders) are, by and large, poverty stricken individuals. They're desperately trying to better their lot with a new life in the promised land. They'll settle for low paying jobs, welfare, free education for their kids and U.S. taxpayer subsidized housing and health care.
But a large part of the 400,000 member exodus is made up of wealthy people seeking to escape the growing tax and regulatory tyranny the U.S. government aims right at them. And it is this gusher of fleeing rich people who take with them U.S. wealth -- and the U.S. tax base. These are the very people who pay for the all those programs the new immigrants covet.
Two years ago next month I referred readers to what was then Kevin Phillips' latest book, American Theocracy: The Peril and Politics of Radical Religion, Oil, and Borrowed Money in the 21st Century. In it he put together an amazing array of historical, religious, economic and political data to argue that the U.S. was about to join its imperial predecessors on the downhill slide - Rome, Spain, the Netherlands and Britain.
But what was particularly prescient of Phillips in his 2006 book was one of the two major reasons he saw for America's decline. The first was the decline in industrial and manufacturing base. The second was an increase in "financialization" of all sorts of intangible financial services that replaced tangible production.
This astute observation was made well before shocked Americans and the world were to learn about the sub-prime mortgage crisis and before scores of billions of dollars worth of bank and financial losses -- due in large part to the phony "financialization" Phillips warned against.
As Phillips showed, a lot of these modern "financial services" consist of little more than creating new forms of debt, then pushing all those debt papers around while collecting fees for doing nothing really productive.
Tune in tomorrow, and I'll give you my take on what Phillips refers to in his latest book - what some have called "one of the slowest moving train wrecks" in history. Plus, I'll tell you how to avoid this mess altogether...
BOB BAUMAN, Legal Counsel
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China Shares Get Cut in Half, but Don't Panic Just Yet
So far this year, China's stock market lost nearly US$2 trillion in market capitalization. Just to provide some scale, that's equivalent to the entire value of Canada and Germany's stock markets - lost in less than four-months!
The bear market in China reached epic proportions yesterday. The CSI 300 Index, which tracks A-shares (available only to domestic investors), listed in Shanghai and Shenzhen, has now plunged 50% from its all-time high reached just six-months ago. Over the same period, China's output has continued to expand at an average rate of more than 11% - the world's fastest growing economy by far.
How to reconcile these apparent contradictions? Well, that's China for you.
Setting aside the question of whether Beijing's economic data is accurate (just how accurate is ANY government data anyway?), it's worth remembering that China's mainland stock markets operate as a closed system.
It's an unreal world detached in many ways from economic reality. Of course it's still fun to watch this spectacle unfold. First we saw the stunning rise in Chinese share prices - which for the record soared 478% in 2006 and 2007. And now, the equally spectacular decline has arrived.
Shares listed in Shanghai now trade at a more reasonable 26 times trailing earnings - and just 20 times this year's estimated profits - down significantly from P/E ratio of over 70 last year.
And falling share prices only explain part of the cheaper valuation. China's corporate profits grew 48% last year at firms included in the CSI 300 Index. Earnings are expected to rise another 32% this year as well.
Solid profit growth, plus a much cheaper valuation, may lead investors back into A-shares just as soon as some upside catalyst emerges to dispel gloomy sentiment.
The government of course could provide just such a catalyst in the form of regulatory changes. Lowering taxes on retail stock is a great start, and this morning that's just what Beijing announced. Mainland stocks responded with a rally of about 5% overnight. Last year, authorities tripled the stamp duty tax on share transactions, but could provide some relief with more tax cuts.
Another idea is to loosen restrictions on foreign institutional investment in China's mainland markets. Entirely doing away with the cumbersome dual listing structure of A-shares (for Chinese investors) and B-shares (foreign investors), would be another positive step.
Beijing might even consider the more drastic step of using some of its $1.7 trillion worth of currency reserves to prop up share prices directly. After all, the government has dipped into its sovereign wealth before to bailout the banking sector - so why not the stock market? Remember, mainland China isn't an open market...it's a rigged game.
After all, China has said publicly that it wants to "diversify" its currency reserves!
Meanwhile, with Shanghai stocks down 40% so far this year, I still believe the best ways to invest in China today are through Hong Kong and Taiwan...the unrestricted gateways to Chinese stocks.
Hong Kong's Hang Seng Index, which includes many H-share listings of top Chinese firms, is down just 10% in 2008. Taiwan is actually up 13% year to date, buoyed by recent election results that promise closer ties to mainland China.
These two markets still offer you much better bargains than mainland Chinese shares, even at 50% off!
MIKE BURNICK, Senior Editor & Global Market Analyst
P.S. To read my full, uncut story on this spectacular market decline, see my blog right now. Also, I've recommended several plays that give you cheaper and safer access to fast-growing Chinese companies. You get maximum upside potential, while strictly limiting your risk. For all the details, check out my Market Shock Trader service. Click here to take a test-drive so you can get in on these plays on the one market that looks to emerge from its spectacular decline.
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