Bubble, Bubble, Toil and Trouble: Playing the Emerging Markets

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Originally Published December 2007

You and I know that one day the orchestra will stop playing and the wind will rattle through broken windowpanes. We are all at a wonderful party and by the rules of the game we know that at some point in time the black horsemen will burst through the great terrace doors to cut down the revelers; those who leave early may be saved, but the music and wines are so seductive that we don’t want to leave. But we do ask, “what time is it?” Only none of the clocks have any hands.

Adam Smith, The Money Game, 1967

So much money has been sloshing around the globe in search of an “above average” return that even risky assets have been bid up tremendously. At this stage, however, with new holes in the financial dike showing themselves almost weekly – more holes, we suspect, than officialdom has fingers – the money flows are building toward a reversal. This will hammer the emerging markets the hardest because, historically, in times of crisis, capital packs up its bags and goes home. When that happens, shares of good companies get sold at the falling bid simply because the seller must get liquid, whether to calm his fears or to cover his losses elsewhere. Asset prices become screaming passengers strapped in to a luge ride.

This creates opportunity, of course. Even though the economies of all the most prospective emerging-market countries are strong enough to weather any likely storm, their financial systems aren’t. This is emphatically true in India, China, Brazil and other fast-track economies. Even so, when foreign financial capital has fled, the physical and human capital will remain, it will still be valuable, and good investments will be cheap in the extreme. But the opportunity won’t be available for everyone – just the investors who’ve been patient.

Buying an investment and waiting for harvest time is the easy part of patience. The hard part is waiting to buy. Investors want to invest. It’s in their nature to expect, without considering the alternative possibility, that there should always be something worth buying. Usually there is. The danger, the psychological trap, is in the “always.”

If you follow the financial talk media, you get plenty of reinforcement for the urge to buy. Long-boom myths like “dollar cost averaging” and the media’s third-hand tellings of modern portfolio theory assume that prices always rise. Every dip is a guaranteed buying opportunity. No dip can turn into a plunge, but if it does, it’s the buying opportunity of a lifetime. All setbacks are temporary, a winding of the spring that will power the next big advance, the one that’s coming soon. Long, dark nights don’t happen.

Were you in the business of managing other people’s hard-earned savings and your compensation depended on outperforming another guy with the same mandate, the ever-buy approach could work for you. Quarter by quarter (or at least year by year), turn in a performance that’s above average, and you collect your bonus – no matter how ugly the average might be.

But nobody we know who loses a third of his home value or watches half his 401k disappear will be doing the happy dance just because his neighbor’s house went into foreclosure or his brother-in-law’s employer went bust. When you are investing your own money, the measure of success is how much stuff you can buy (i.e., purchasing power), not whether you outdo the poor sap next door. That so much of Wall Street thinks differently is part of the danger in today’s environment.

According to the drivel on CNBC, the “experts” are still expecting the rise in asset prices to continue, based on “relative prices.” The assets that have lagged in price are going to catch up. They just have to. This is utter insanity in our book, but the thinking is widespread, so we thought it important to tell you how we look at it and, perhaps more importantly, what we are doing with our portfolios as the unprecedented, worldwide asset bubble approaches the spatter point.

Unprecedented? Well, you are right to flinch when anyone says “it’s different this time,” and certainly we don’t pretend to be a definitive source on economic history. However, we are concerned because we know of no other time when:

1. Yields are low on traditionally higher-risk assets: By now everyone is aware of the subprime problems, but that’s only the tip of the iceberg. Sovereign debt issued by countries that have, in the past, failed to meet their obligations is now trading at a premium to par rather than at a discount. With all the liquidity pouring into the system from the Federal Reserve, European Central Bank, Bank of England and Bank of Japan, long-term rates are ridiculously low given the true inflation numbers. Fuel and food prices are more than doubling, but yields are going down? Doesn’t make sense to us. Abnormal. Unsustainable.
2. Capital has become so mobile and fickle: Never before has capital moved so quickly, regardless of origin or destination. With the push of a button, trillions now flow in and out of markets dominated by hedge funds, sovereign wealth funds, banks and even retail investor accounts. While herd mentality has always been a powerful force, today the herd is far bigger, faster and twitchier — especially in emerging markets (ex-China), where the bulk of the capital is controlled by foreign interests that have no problem running for the exit when someone hears a twig snap. Sentiment changes and markets tumble. Black was in Brazil this month and found that, among the Brazilians he spoke with, sentiment was uniform that the local stock market and currency were too high… so they wanted to talk about buying U.S. homebuilders. The Chinese are sending their markets through the roof based on how “lucky” the numbers in the ticker symbol are thought to be. Nutty? We think so.
3. Globalization and protectionism are growing at the same time: We have a strangely schizoid situation. Growth in global trade is what’s keeping the world economy afloat. But now producers are selling to high-debt consumers. As chronicled so eloquently in Casey Research’s publication, the International Speculator, foreigners are buying U.S. debt with both hands, or at least they were. Now, as tough times seem destined for our shores, politicians and the man in the street will start looking for a “them” to blame… hey, much of the Republican advertising now appeals to anti-foreign sentiment, and the public seems serious about walling up the southern border. This blame game threatens a return to protectionism, which would spur the rapid decrease in asset values that we expect.
4. A global vacuum exists politically and militarily: The bipolar security regime that lasted for half a century ended in the early 1990s with the fall of the Soviet Union. It was followed by a global power vacuum that persisted for about one minute, maybe two, and then was filled by the U.S. and to a minor extent its allies. The uni-polar world led by the United States lasted until 2003. Now U.S. land forces are stretched beyond capacity; those not already committed are armed with little more than harsh language; and public support for military action anywhere diminishes by the day. International receptiveness for U.S. leadership is nil. At the same time, Russia and China are cooperating to an unprecedented degree as Putin rightfully displays his angst over missiles in Poland. At any other time in history, this would be DEFCON news, but today it goes almost unnoticed. With member states in complete disagreement on the way forward, NATO is no longer a coherent organization. Something as seemingly small as Kosovo independence could cause the delicate situation to fall out of balance.
5. Massive wealth is accumulating in immature markets: Historically, developed markets are the center for global wealth because they have the infrastructure, information systems and scale of capital. That’s changing, and it’s not necessarily a bad thing, but the transition is hazardous. Not since the United States embarked on outdoing Europe’s industrial revolution has there been such a jolting shift in where wealth is created and power is focused. Events of such magnitude are often marked by the unexpected and the uncontrollable.
6. Stocks in most markets have run up and run far, but without the benefit of underlying fundamental strength: For a given market, this is anything but new or surprising. Investment manias show up more often than cicadas and are just as noisy. But seldom do stocks in almost every local market climb to dizzying heights simultaneously. Excess liquidity, fear of inflation and a falling dollar have led big players who are looking for tangible assets to pour money into questionable equities. As mentioned above, however, when trouble strikes at home or the awkward questions get their awkward answers, liquidity will dry up, and the margin casualties in one market will be forced to sell what they can in other markets.
   It’s not a solitary bogeyman that worries us, it’s the legion. In 2000, when the NASDAQ was getting completely silly, markets in Eastern Europe were just starting their run, and Asian, South American and Russian markets were still in the dumps. Today the dumps are depopulated — plenty of markets near their tops and none that we can see are near a bottom. Throw in the high prices on risky assets, the flightiness of capital, the public’s new receptiveness for protectionist measures, the free hand that so many governments now have for geopolitical and military adventure, the surprises waiting to be delivered by the shift of wealth and power from West to East… all that, and a train wreck seems unavoidable, even if we don’t yet know the exact spot on the tracks.

So What to Do?

“But I have to do something now! That’s why I am paying you two dunderheads!”

We know you’re not paying us your hard-won cash simply to hear about problems. We also know that we’re not omniscient, but nonetheless there are some basic ingredients to our method and strategy that may be useful for you.

Although we’re not committed to any portfolio theory, modern or otherwise, here is how we divide up our little bag of pennies. First, we split it into two piles, “investments” and “speculations.” How you divide your net worth between the two depends more on your personality and psychology than anything Nobel laureates Black (no relation) and Scholes could come up with. We are temperamentally inclined toward speculation, but that’s just us. We recommend that you not allocate any more for speculation than you are prepared to lose without losing sleep in the bargain and without compromising your marital bliss or cheerful disposition.

Having made the big split between the investment pile and the speculation pile, here’s how we handle each of the two, given our expectation that the next big opportunity will come from big trouble in the emerging markets.

Investments:

1. Physical gold and silver stored in multiple locations, ideally in multiple countries
2. Gold and silver ETFs or certificates in accounts in multiple jurisdictions
3. Larger, but not the largest, oil, gas and mining companies
4. Emerging market agricultural land and income-producing properties

Speculations:

1. Junior resource exploration stocks
2. Early-stage private companies in emerging markets
3. Emerging market bonds (but not yet!!!)
4. Selected foreign stocks — either shares that can weather a correction or, more likely, those we want to buy after the correction
5. Emerging market real estate developments with compelling demographic fundamentals

The Watch List

Essential to our strategy is a Watch List. It notes stocks we like because the companies are solid and can survive or even thrive in a downturn or outright crisis — but that we are only watching, not buying, because right now they’re so pricey. We screen these companies by conducting sensitivity analysis to determine how they would hold up in different scenarios, for instance, high inflation, declining dollar, a global sales slowdown, etc. Currently we have a list about fifty deep, but it’s not static; we’re always open to adding or dropping a company.

For each stock, we develop a target price where we would want to start accumulating and a lower price where we would want to back up the truck. Then we wait. We wait for a panic, when people either overreact or are forced to sell by margin calls, a bank holiday or some other disruption.

Right now, our watch list is heavily populated with stocks in Hong Kong, South Korea, Australia, Vietnam and Brazil. Although these countries have solid economies, we believe the shares will pull back, in some places severely, before they make their big run. So as painful as it may be, sometimes the best thing to do is nothing. We will be your eyes and ears on the lookout for the right time to buy, and we’ll alert you immediately when that time comes.

Sell or Average Down?

So you already own emerging market stocks. Should you sell? Well, since we allow people to believe we’re experts, we’ll tell you… that it depends. We personally aren’t comfortable owning most stocks in emerging markets right now, but we realize that selling could mean missing out on further profits should the mania continue. So if you own a stock you think will outperform a rising market and you are willing to suffer through what could be a 20% to 30% drop over the next several months to a year, we won’t nag if you decide not to sell. But remember, a stock has to go up 100% to bounce back from a 50% correction.

So if you aren’t selling, do you average down? By this we mean buying more as prices fall. For a few stocks, yes. We have been buying Bladex (BLX: NYSE) (see Without Borders, September 26, 2007 edition) on the dips and are comfortable it will weather the storm well and even thrive in a banking crisis. Because we believe in the company and understand the business model and how they make money, we’re not unhappy when “Mr. Market” lets us accumulate more shares at even better prices. (We can’t say that for the larger caps that are already heavily touted by the regulars in lower Manhattan and the City of London.) We don’t know how to call a bottom or a top, but except where we alert you otherwise, we’re not averaging down. We’re waiting for a cliff-edge drop that will deliver the kind of buying opportunity that reminds everyone why cash is good.

Shorting? Lord Keynes and All That

John Maynard Keynes is credited with “The market can stay wrong longer than you can stay solvent.” In all fairness, we’ve also read that he didn’t say it, but we nonetheless agree with it. Shorting is tricky business, like stealing electricity, and especially so in emerging markets. We don’t recommend shorting, at least not for now, because we are dumbfounded that prices keep going up. And we recognize that we may continue being dumbfounded for some time to come.

Market psychology is as unpredictable as dice. What we are seeing now is like the magician’s trick of piercing a balloon with a knitting needle. The needle goes through the balloon and comes out the other side, yet the air stays in. We don’t know how it’s done, but we don’t believe the central bankers and the pinstripe Houdinis have many more tricks up their sleeves. Still, as long as the audience believes they do, prices could keep going higher. Earlier this month, when all the big central banks of the world held hands and dumped a bucket of cash into the system, we were convinced that the sheer magnitude of their efforts would show the markets how grave the situation is. Instead investors were heard shouting, “Have no fear, Central Bank is here.”

But if you crave excitement and need to be short something, we think the S&P, NASDAQ, DOW, FTSE and other markets are good candidates, and you can scoop up short/ultra-short ETFs like QID, SH, SDS, and DOG.

SH: Seeks daily investment results, before fees and expenses, which correspond to the inverse of the daily performance of the S&P 500 index.

QID: Seeks daily investment results, before fees and expenses, which correspond to the inverse of the daily performance of the NASDAQ-100 index.

DOG: Seeks daily investment results, before fees and expenses, which correspond to the inverse of the daily performance of the Dow Jones Industrial Average index.

SDS: Seeks daily investment results, before fees and expenses, which correspond to the inverse of the daily performance of the S&P 500 index.

Each of these ETFs and others like them offer the investor the opportunity to take a short position and only risk the capital used to purchase the ETF. No worries about margin calls. The only problem is you don’t control the mix in the short position. The managers do that for you based on a predetermined algorithm. This doesn’t bother us because these are macro calls and we think the premium for simplicity is worth it. There are also a series of more specific ETFs designed to target a specific sector. They require a bit more individual research because their formula for shorting may be different than you would expect. For more information, go to http://finance.yahoo.com/etf/browser/op?c=etf_bm

Emerging Market Bonds

The time is coming when select sovereign and corporate debt in the emerging markets will be very attractive to the crisis investor. Such issues always oversell in a correction. Anyone who invested in Russian debt in the late ‘90s, for example, made a spectacular return. Good securities will be trading at discounts of 30% and up. Yields will be more than high enough to compensate for the inflation likely to ensue, and the bonds can be a good source of currency diversification. But not now. The liquidity provided by central bankers turned helicopter pilot has pushed these bonds to a premium and, in our estimation, way above an acceptable level of risk. But just wait a bit. The panics to come will make the bonds lovable.

Overall Assessment

As we pen this in December, we find that many investments are priced out of our comfort zone. Emerging market run-ups are being fueled by the trillions of dollars trying to find a temporary home. When that home starts growing mold, the trillions will pack up and head back to civilization (provided capital controls don’t stop them at the border). We have a long list of solid companies with solid management and sound business models that we are watching while we wait for the right opportunity to buy. If we recommend something along the way, it’s because a particular company or security satisfies our comfort level. But right now so few do that we are buying gold and real estate and husbanding cash for the big opportunity. Remember that the key to real success is to be bold when others are timid and timid when others are bold. Today, as we raise our field glasses to survey the investment and speculative battlefield, our helmets are pulled down low and our knees are trembling. We’re not just timid but downright cowardly. Our only boast is that we have the courage to admit it.

Editors Note:  Do you like what we have to say here?  Why not try a subscription to Without Borders.  It isn’t for everyone. Sheeple and Lemmings need not click here.  But if you are independent minded, liberty loving and have a penchant for contrarian thinking try it now. If you don’t like it we’ll give you your money back.