China: Ascendant Superpower Or Just Another Nation with Structural Problems? 

April 24, 2009 

A number of commentators are claiming China is poised to replace the U.S. at the top of the nation-state heap in terms of global influence. Perhaps the realities of adding/subtracting superpowers are not quite so superficial.

NOTE: "Big nose" is Chinese slang for a Caucasian.

Correspondent Cheryl A. recently sent in two articles on China's ascendency with stake out the extremes in the thesis. The first is The great shift in global power just hit high gear, sparked by a financial crash: As an emboldened China sees, the American dollar is gravely wounded. And the days of US political supremacy are numbered.

Author Martin Jacques (whose book, When China Rules the World: the Rise of the Middle Kingdom and the End of the Western World comes out in June) posits that the coming collapse in the dollar and its replacement with a new international currency hosted/supported by China augurs a global shift of superpower status from the U.S. to China.

Meanwhile, on the other end of the spectrum of opinion, geopolitical pundit George Friedman suggests that the idea China is poised to replace the U.S. is roughly equivalent to similar claims made in the late 1980s about Japan replacing the U.S. KGB INTERROGATION: George Friedman.

Interviewer Alan Kohler: George, the assumption is that we’re witnessing the transfer or the shift of geopolitical power from the US to China and that this has been sort of if anything accelerated by the global financial crisis, but you’re predicting that China will fragment by 2020, in your book. Can you explain why you think that and why the global financial crisis will not prevent it?

George Friedman: Well, in the first place you have to remember that China is very much a Third World country. Of the 1.3 billion Chinese, well over 1.1 billion have a standard living on the order of Nigeria. If you go to Shanghai and drive to Pudong, you can get the illusion that this is a European or American country, but just walk blocks away from the centre and you’ll see a very different China.

Secondly, the Chinese economy is a hostage of the foreign international system, but primarily of the American economy. China is incapable of domestic consumption on the order of production. So, when the United States catches cold, China gets pneumonia and that really is an important thing to understand – that China does not have an economy as we understand it in the sense of substantial domestic consumption. The Chinese economy is overwhelmingly export-oriented and therefore China is a hostage to its consumers.

Some context for these two disparate stories can be found in my essay China: An Interim Report.While I wrote this back in 2005, the issues it addresses-- financial fraud/misrepresentation, corruption, pollution and a command economy--are all very much in play.

It may strike many as odd that the issue of China's ascendency can draw such irreconcilably opposite opinion. I believe the fundamental reason is that it is easy to draw superficial conclusions about China (and Asia in general) because much of what matters in Asian nations and cultures occurs below the surface and is not discussed in public.

The reason is "face": the sense of public shame which has no real analog in American or indeed Western culture. In Asian societies, one does not air private "dirty laundry" in public. This is true of embarrassing or potentially shameful issues of individuals, families, companies, and the nation as a whole.

Anyone who thinks that a Big Nose can waltz into Shanghai, Beijing, Tokyo, Seoul or Bangkok and get a straight answer about less-than-glowing situations is misguided. Officials will happily show Big Nose know-nothings a glitzy superficial surface while carefully skirting any embarrassing flies in the ointment. In other words, Big Nose bigshots will be shown Pudong and fancy hotels in Shanghai but will never get access to dirt-poor villages filled with restive, combustible peasantry.

A supposedly "open" society can close off with remarkable speed, and the chatty guide can turn stone-faced and unfriendly in very short order.

Though Asians typically are highly attuned to the need of others to "save face," the opportunity to put a better face on complete catastrophy will always be taken. Thus special rice fields were grown on either side of a specific road just so Chairman Mao could be driven into the countryside to see the bountiful rice crop being grown, even as millions of his countrymen and women died horrible deaths from a mass starvation brought about by the policies of Mao's government and the CCP (Communist Party of China).

In other words: nothing is as it seems in Asia. Does this mean China's growth is illusory? No, but it does mean China's structural problems are masked as a matter of course and will always be masked as a matter of course.

Thus, while China's leadership expounds publicly on China's great prosperity, they're secretly buying houses for cash in Vancouver B.C. and Los Angeles, CA as retreats for their own families should things head down in China. Hmm, why would they do this if they really believed in China's ascendency?

Ignorant Big Noses often respond to face-saving measures with disbelief and anger. Why did they lie to me? Ah, but it wasn't a lie; it was simply the public expression of saving face. To expect the embarrassing truth to be stated publicly is to expect the impossible.

Thus the Big Nose visitor will be shown the new water treatment plant, but not told the filters are never changed because that's too costly. The Big Nose will be shown the belching factory closed by regulators in the day, and not the factory covertly operating at night.

The Big Nose will be enticed to build the pharmaceutical plant but not shown the perfect copies of his products which contain no medication that are sold as "the real thing" at enormous profit to the counterfeiters and enormous harm to consumers seeking remedies.

The Chinese media reports a manufacturer who was making exact copies of Japanese motorcycles has been shut down, but does not report the shop opened up in a nearby city a week later. And so on.

The Chinese have learned the value of bogus statistics from the masters of deception in the U.S. government, which routinely misprepresents inflation, unemployment and other key statistics as a matter of policy, lest the "bad news" spark some demands for change in the status quo. As a consequence, we should view all "official" statistics issued by China with the same skepticism that we view bogus U.S. government statistics.

But unlike the U.S. government, China's central government directly controls all the important levers of economic and financial activity. Copper being stockpiled? Only the government knows. Interest rates mandated lower? The government ordered the banks to do so, end of story.

All of which is to say that only those with access to the highest levels of local government can say what's actually happening in China."Growth" numbers can be juiced, but electrical consumption is harder to flim-flam, and so on--but even electricity stats can be massaged. I say "local government" because I suspect not even the Central Government really knows what's going on at the local level, because reporting bad news would not only result in a loss of face but quite possibily a loss of position and prestige.

That's an "unintended consequence" of a command economy selectively utilizing an "open market Capitalist" model.

For better or worse, the U.S. decline and the consequences of our profligacy, addiction to debt, corrupt and venal banking sector and all the rest are aired 24/7 globally. Want to puncture Yankee hypocrisy about slavery in the pre-1860 Northeast? No problem, the data is on the Web.

Nothing delights a skeptical, suspicious-of-authority American as much as the exposing of official chicanery and the confirmation of our deepest suspicions about corporate skulduggery and government lies/manipulation. But in Asia, such revelations are a national embarrassment to be swept under the rug at the earliest possible convenience. "Self-criticism" is an exercise in stating the unavoidable and then using that confession as an opening to revel in the weaknesses of others.

As for the dollar's demise leading to China's rise: it isn't that simple. I would rephrase As an emboldened China sees, the American dollar is gravely wounded. And the days of US political supremacy are numbered to:

An increasingly desperate China sees the dollar as doomed and seeks an alternative as an act of self-preservation. That all fiat currencies are doomed is easily anticipated; but the process of their mutual decline is far messier than such superficially breezy pronouncements make out.

The dollar's demise has been announced for years, and yet perversely, it has refused to lower itself politely into the grave. Perhaps it will be the euro which expires suddenly, leaving its host nations in shock. Perhaps it will be the yuan which is shunned as China's export economy continues to unravel. Perhaps it will be the yen which is sold off as a poor hedge against a decline in relative value.

As opined here before: the question is not which fiat currency loses value against gold, but which one loses value faster. A replacement currency may not take shape as expected; there may be various alternatives such as a private gold-backed "quatloo" for global business transactions or a regional currency backed by a basket of commodities which includes petroleum and other tangible commodities in high demand.

Perhaps a private grain-backed currency will draw upon the grain exports of North America as the only "real wealth" of nations. Would you buy a wheat-backed "quatloo"? I personally would be interested in trading paper for wheat, gold, oil or anything more valuable than paper.

In other words, another fiat currency will not replace the dollar because it offers little to no advantage. We already have more than enough paper money, and a yuan will devalue just as rapidly as a regional currency backed by nothing more than promises of paper value.

And if there are any last words on "superpowers" and "global supremacy," I would look not to currencies alone but to the health of a nation's citizenry. At this point, it's a race to the bottom: which nation kills off its citizenry first: the U.S., with its illness-producing glorification of a fat and sugar-loaded diet which has sparked an obesity epidemic, or China, whose poor air quality is shortening the lives and productivity of hundreds of millions of its citizenry.

Maybe it won't be one superpower or two superpowers, but no superpowers: just a collection of nation-states of various sizes, all of which face a long list of structural problems. 


New excellent reader essay, a provocative must-read:

Madoffing the U.S. Financial System (Zeus Y.) 


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First In: An Insider's Account of How the CIA Spearheaded the War on Terror in Afghanistan

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Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life

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Thank you, Michael B. ($50), for your outrageously generous contribution to this site. I am greatly honored by your support and readership.

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Look Out Below 

April 23, 2009 

The stock market looks poised to turn down, perhaps in a major way. The chart of the past two days suggests manipulation of program buying has juiced bogus "rallies" so insiders can sell to suckers and then go short for the big plummet.

The stock market looks ready to roll over. Consider three charts: Apple, Goldman Sachs and the last 10 days of the Dow Jones Industrial Average: I selected Apple and Goldman Sachs partly because they are considered "leaders" and also because they are in completely different industries. Nonetheless their charts look eerily similar in being very toppy.

As always, please read the HUGE GIANT BIG FAT DISCLAIMER below before continuing which says this is my amateur opinion you're reading for free, it is not investment advice. Disclosure: yes, I am short this market, in a number of ways.

In both cases the stocks are extremely overbought, the MACD is starting to roll over indicating a downtrend is approaching and price is banging on the overhead resistance of the 50-day moving average. As icing on the cake, their long-term MACD has been declining for years.

Given that the indicators are rolling over, the Bull case for additional gains is weak.

If we examine the DJIA over the past 10 days, we see a chart dominated by wild swings-- just the sort of volatility which often marks market tops. Yet the VIX, one measure of volatility, is a modest 38, well below its panic tops above 80. Complacency reigns supreme even as the indicators are rolling over--not a good combination for the Bulls.

Legendary stock trader Jesse Livermore explained decades ago in Reminiscences of a Stock Operator how to manipulate a market higher: start some heavy buying above the bid, which then attracts more buyers (in today's market, that attracts program buying), juicing a faux rally which the manipulator then sells into. Once he's done selling into the manipulated strength, he goes short the market, enriching himself as the market responds to gravity, i.e. there are no manipulators juicing it aloft.

The past few days show the unmistakable spoor of such manipulation to create bogus rallies: sudden big leaps up with no news or other visible stimulus. This is the "bid up" buying which sparks the trading programs to jump in. Then as buying increases, the manipulators sell. Rinse and repeat until they've unloaded their long positions, then they start selling short.

Once their short position is large enough--and of course they eliminated the competing shorts by their sudden "rallies" which triggered all the other shorts' stops--then they stop their buying and the market falls under its own weight, picking up momentum as traders (and black box programs) grasp that buying has dried up.

If you don't believe this is possible, please read the book and brush up on how black box program trading works: seek a trend and pile on.

No real Bull market starts with a sharp V recovery. Any rally worth its salt begins from a double bottom. This is a psychological truism--investors don't trust a rally is real until it re-tests its low and holds. That suggests the markets will at a minimum return to their March 6 lows. If those fail to hold, then a new low wil be reached. Can't happen? Maybe not--but these are not strong charts. These are charts just waiting for the last manipulated buying to cease so they can roll over and plummet, reaping those who built short positions major fortunes.

If there are any investment banking profits next quarter, they'll be reaped selling the rally to suckers and shorting the living heck out of it just before it drops 25%.

New excellent reader essay, a provocative must-read:

Madoffing the U.S. Financial System (Zeus Y.) 


What's for dinner at your house? has been updated with a new recipe: Eggplant Parmesan . This a mouthwatering photo-illustrated PDF from longtime contributor Bill Murath.

Of Two Minds reader forum (hosted offsite, reader moderated) 


Operation SERF Book One is now complete:

Operation SERF (all 12 chapters)

Chris Sullins' "Strategic Action Thriller" is fiction, and on occasion contains graphic combat scenes. 

Thank you, Anthony M. ($25), for your most generous contribution to this site. I am greatly honored by your support and readership.

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Obama's Secret Plan 

April 22, 2009 

In which we speculate that perhaps Obama has a secret plan to discredit the investment banker cabal and thus undermine their vast political power and reach. (Note new readers' essays below: "Madoffing the U.S. Financial System" and "Why We Are the Way We Are".)

Many observers, partisans non-partisans alike, have been mystified by President Obama's continuation of the Bush/bankers/Treasury's "privatize bonuses, socialize risks" campaign of taxpayer-funded bank bailouts, phony slight-of-hand "transparency" and political support for blatantly bogus accounting of banks' profits, assets and losses.

The failure of the Obama administration to pursue real regulatory "change" (such as actually enforcing regulations that are already on the books instead of throwing bankers new squeeze toys like "relaxed" mark-to-fantasy accounting) has moved many from mystification to outrage.

Where's the "change" in this continuation of Bush/bailout policies? What is the rationale of a supposedly "progressive" president in filling his financial administration with "investment banker Borgs"?

Let's begin our speculation with a question: if a new President (of either party) wanted to destroy the political power of the investment banker cabal which currently holds sway over Treasury and Congress, what path would actually lead to success?

Does anyone seriously believe that a new President could dent the vast political power of the Financial Aristocracy with a Jimmy Stewart-like speech excoriating the bankers and their minions for gutting the U.S. economy? The chances of that having any effect are zero.

How about tightening regulations? And what happens when lapdogs in Congress quickly rush to gut the regulations or the regulatory forces supposedly empowered to enforce them? If you doubt the power of bankers, please look at what has happened to attempts to limit the most egregious excesses of credit card usury and outrageous junk fees: they're thwarted or watered down every time.

Does anyone seriously believe an obstructionist opposition which supported Bush's giveaways and staggering deficits for eight long years has any credibility? The moment to do something about deficits was 2003, and the moment to vote down bailouts was last Fall (hmm, now there's an appropriate season) when the TARP debacle was shoved down the nation's throat by the Financial Aristocracy.

Does anyone seriously believe the Democrats who cheerily absorbed millions in donations from scalawags and crooks in Fannie Mae, Goldman Sachs et al. while obstructing regulations which might have limited the damage have a lick of credibility? To be a partisan in this age is to be either blind or brainwashed.

So let's face it: any President who sought to destroy the political power of the Investment Banker Aristocracy in a frontal assault would be defeated if not destroyed. Any president of either party who dares even mess around the edges of the real power structure gets "the treatment."

Is there any strategy would might actually work? How about "give them enough rope to hang themselves"? President Dwight Eisenhower has long been dismissed as a do-nothing who "got lucky" in his two terms. Perhaps--but he was also a canny politico who didn't say much because he preferred to give his opponents plenty of stout rope. And sure enough, most of the time they promptly hanged themselves with their own excesses.

If you set out to completely discredit the bankers and eviscerate their political power, you'd proceed exactly as Obama has done, enabling it to reach its reductio ad absurdum conclusion of fat bonuses and tax-funded bailouts in the trillions of dollars, at which point the public will rise up in fury, doing the work which was impossible for you, a new "liberal" president.

Imagine the uproar had Obama sought to send the bankers straight into deserved bankrupty and eliminated their looting; he would have been thwarted and second-guessed at every turn by politcos, pundits and the ultra-wealthy Aristocracy whose perks and privileges were threatened, not to mention a Republican Party spoiling to be spoilers.

What better way to discredit the bankers than to give them plenty of rope to complete their tarnished, fraudulent "plan to save Capitalism from itself"? How can they complain when their own bankrupt policies have been supported?

What better way to trigger "change" that even the banking Aristocracy are powerless to stop than to give them everything they want: no restrictions on stupendous bonuses, no punishment or prosecution, no mark-to-market rules with actual bite, no limits on accounting legerdemain, and on and on and on?

You want the sharks to gather? Then keep chumming the water with banker-designed policies; hey, even denounce the tax rebellion movement as "off base." Make like you're doing the banker/Plutocracy's bidding in every possible way. And what will be the result?

A complete repudiation of the entire Bush/Treasury/banker bailout and "free pass" to further plundering. And when the public rises up in righteous fury, then you appear to bend, almost reluctantly, to "the public will."

If you set out to gut the political power of the banker/financial Plutocracy which holds Congress on a tight leash, this is the only way to do so: goad the public to rise up with such fury that they cannot be denied, lest every politico who seeks to protect the status quo be swept aside in the next election, regardless of party, age, religion or any other bastion of "voter support" they were counting on to save their bacon from an aroused public's righteous wrath.

If Obama had refused to support the bailout, the screams that he was "destroying the foundation of the U.S. economy and our way of life" would have been ceaseless and deafening, for a stunned and stupefied public had failed to process what was actually happening beneath the MSM propaganda about "saving the banking system to save the nation."

Obama can now say, "I did everything you wanted." Is it a carefully craft Secret Plan or merely the fumbling of a status quo politico? Either way, it's brilliant because it's the only possible pathway to a future not dominated by trickery, fraud, collusion, obscurity, propaganda and the looting of what's left of the U.S. Treasury and economy.

Can abject, impoverished debt-serfs distracted by hundreds of channels of idiotbox TV, iPods, American Idle, oops, I mean Idol (now there's a Master's Thesis topic for ya), "professional sports" (a.k.a. gladiators and circuses) and all the other avenues of marketing which are sold as "entertainment" rather than what they really are, propaganda and distraction-- can a nation of debt-serfs actually awaken from their "entertainment" stupor long enough to register outrage at the looting of their nation and liberties by a small Plutocracy?

We shall see. If the looting which is finally sinking through the endless layers of propaganda doesn't spark a bloodless revolution demanding real change in who actually runs the nation's policies, money and regulatory structures, then nothing will.

Is there even a shred of evidence that Obama might have thought this out one layer deeper than 99.999% of the bankers, critics, pundits and opponents? perhaps one: Paul Volker. Volker--remember him? Where has he been? Trussed up and gagged in some Treasury basement? He'd slipped from the media radar until very recently, when he somehow escaped from the duct tape and Treasury guards and had the audacity to stand up and call inflation targets pure theft.

Whew. Was that a breath of fresh air or what? I see two possibilities: either Obama really is just another standard-issue tool of the Financial Plutocracy, and Volker resigns in disgust within a year to protect what's left of his once-sterling reputation, or Obama is giving the Banking Plutocracy all the rope it needs to hang itself. In that case Volker is the "Trojan Horse" in the system, the one who will emerge after the extremes have finally goaded the public to an anger which cannot be diverted by propaganda and "entertainments."

So watch Volker. If he resigns, then Obama truly believed the absurdity that bailing out the bankers and enabling their continued looting of the nation is "the fix we need." If Volker stays, even in the shadows, there may be more intelligence afoot in our leadership than has yet been revealed. 


Two new excellent readers' essays, both provocative must-reads:

Madoffing the U.S. Financial System (Zeus Y.)

Why We Are the Way We Are (Subuddh Parekh) 
Thank you, Norman W. ($10), for your very kind and generous contribution to this site. I am greatly honored by your support and readership.

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Why Housing Is Not Coming Back 

April 21, 2009 

The financial MSM and government officials alike are looking for a recovery in the housing market to bubble valuations to "restart the economy." That is not going to happen--not this year, not in five years or even in ten years. Here's why.

The entire world is hoping that housing is about to "recover" and re-ascend its glorious bubble-era heights of valuation. But it's not going to happen.

Why not? For several fundamental reasons:

1. Bubbles do not re-inflate in the asset class which just popped. It is simply a truism that bubbles never reflate, ever. Tulip bulb valuations did not rise to stratospheric heights after the Tulip Craze popped, and the Nasdaq dot-com bubble did not reinflate, either, for the very good reason that bubbles are never based on rational valuations--they are based on the psychological state of mania which cannot be reinstated once lost.

Consider tech stock Cisco Systems (CSCO), a well-managed "real company" which continues to make profits providing real-world goods and services. It currently trades at around $17.50 a share, down from its dot-com bubble valuation of about $81/share.

To "recover" its bubble-era valuation, Cisco would have to rise five-fold. That's not going to happen. Now that the mania has dissipated, Cisco is valued on more rational metrics like earnings, profits, etc.

The speculative mania always moves on to a new asset class. After the dot-com bubble popped, the speculative bubble moved on to housing. Now that the housing bubble has popped, the mania has moved to the bond market. When the bond bubble bursts (it's guaranteed that it will in the next two years, losing 50% or more in the process) then the only asset class which hasn't already been blown into a bubble is precious metals/gold.

In other words: those wishing to catch the next speculative mania should be buying gold and silver, not stocks, housing or bonds.

2. Inflation sets the "recovery" target ever higher. While we are in a deflationary period right now, a serious amount of inflation occurred between Cisco's top in January 2000 and the present. According to the BLS Inflation Calculator, $81 in 2000 is $100 in current dollars.

So Cisco would have to rise not to $81 to match its bubble-era valuation but to $100. The same is true for housing. Consider the possibility many see on the horizon, a period of high inflation caused by the insanely stupendous rise in paper money supply.

I am not predicting such an inflation, just speculating on the effects it would have on bubble-era valuation calculations.

Let's say a house which sold for $100,000 in 1997 was valued at $400,000 at the housing bubble peak in 2006. I fully expect the property to retrace to its pre-bubble valuation, as that is the usual progression of bubbles and their demise.

Now if inflation ramps up and ravages the value of the dollar, the price of a tangible good like a home might well rise more or less along with inflation, as people will be trying to turn their rapidly devaluing dollars into some tangible good as a means of preserving wealth.

But if inflation is clipping along at 10% a year and the house returns to its bubble-era value of $400,000, does the $400,000 retain the same purchasing power as $400,000 in 2006? No.

For an example of how this works, consider the stock market in the inflationary period of the 1970s:

While the stock market went from 1,000 in 1966 to 1,000 in 1982 14 years later, inflation destroyed 2/3 the value of the dollar. According to the BLS, $1 in 1966 was worth 34 cents in 1982, meaning those who held stocks for those 14 years did not retain their wealth as the Dow Jones remained at 1,000--they lost 2/3 of their wealth.

It is easy to foresee the same thing happening in housing should inflation ignite.Over the next 14 years, the house which sold for $400,000 in 2006 may well rise once again to that nominal price, but the inflation-adjusted value could well be closer to $100,000 when priced in 1997 dollars.

This is why nominal prices in stocks, housing, bonds and gold are essentially meaningless. All assets have to be valued in terms of purchasing power, and as imperfect and flawed as any inflation/deflation gauge might be, it's still a better guide to purchasing power than nominal price.

3. Perhaps counter-intuitively, deflation also ravages bubble-era valuations. You might think that if inflation is tough on bubble-era valuations when priced in purchasing power (or some non-paper metric like gold), then deflation would be dandy. But deflation wipes out bubble-era valuations just as assiduously as inflation.

In deflation, debt grows ever more burdensome as money becomes more valuable and wages and income drop. As a result, assets dependent on debt ( that is, real estate) drop in value. In deflation, real estate become a "capital trap" which loses value as cash gains in value. As incomes plummet, so do rents, i.e. the income stream which real estate earns, further impairing its value.

Deflation often accompanies depression, and nothing is more of a capital trap than an empty house or building earning zero income. Compared to that, cash earning interest looks very attractive. This creates another drag on housing valuations.

So whatever the future holds, deflation or inflation (or periods of one following the other), housing will never return to its bubble-era valuations when measured by purchasing power/adjusted for inflation.

4. The fundamental driver of the housing bubble was once-in-a-lifetime low interest rates and loose/fraudulent lending.

Bond yields (and thus interest rates) tend to move in generational cycles of about 20 years-- occasionally as short as 17 years and as long as 27 years. The current decline in yields has now run 27 years which the historical maximum for such cycles, and thus we can safely predict that yields and interest rates will be rising for the next generation.

Why would interest rates rise? Easy--the U.S. is borrowing trillions of dollars a year and once the rest of the world either runs out of cash or the desire to give us all their surplus capital then interest rates will rocket regardless of what the Fed or U.S. Treasury do. (Recall the analogy of the Financial Royalty standing knee-deep in a rising tide demanding the waters recede. Good luck with that, fellas.)

As for loose/fraudulent lending--you know the story already. It isn't coming back.

So if the fundamental drivers of insanely low interest rates and insanely loose lending are not coming back, then precisely what forces will reinflate the housing bubble? The answer is: none.

Demographics? As noted here many times, housing density (number of people per structure) has been falling for decades. As density rises, all future population growth can be easily accomodated with the existing housing stock.

Speculative mania? That circus came to Housing Town and left, never to return in our lifetimes (if you're three years old you may live to see another housing bubble in your dotage).

Those counting on a reinflation of housing to bubblicious heights to fuel another manic bout of borrow-and-spend will be sorely disappointed. Housing is never coming back if we define "coming back" as a return to bubble-top 2006 valuations as measured in purchasing power. 


Thank you to everyone who emailed me recently. My computer time has been very limited due to the intrusions of "real life" and so I remain behind in all digital work. Thank you for your patience and understanding. 

Thank you, Dennis G. ($17.76), for your extremely symbolic and most welcome generous contribution to this site. I am greatly honored by your support and readership.

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More on Trend Changes and Leveraged ETFs 

April 20, 2009 

A number of savvy readers wrote to warn me that leveraged ETFs like FAZ are extremely risky due to the manner in which they degrade in periods of high daily volatility. Today we look at DOG, a 1X (unleveraged) Short Dow ETF as another lower-risk way to increase one's wealth in a market decline.

It turns out my "Long Bomb from the end zone" football metaphor was more valid than even I expected. A number of knowledgeable readers kindly wrote to explain that 3X leveraged funds like FAZ (mentioned yesterday: Is the Financial Tide About to Ebb? (April 18, 2009) are extremely risky due to the way sudden sharp increases in the underlying index/basket of stocks can drive them to zero.

Put another way: a long "Hail Mary" pass is inherently risky. It may result in a game-winning touchdown or a game-losing interception. Tossing long bombs every play is not a strategy for winning football games; it must be chosen only at times when risk is drastically reduced--like when the opposing cornerback trips and falls, leaving your wide reciever wide open.

Let's turn to readers' astute warnings:

S.

If the Russell financial index that is the basis of FAZ goes up 33.3% then would your investment goes to a price of a penny and if it then cratered 33.3 percent the next day you would have shares priced at .03? Very risky investment; be careful.

Matt S.

As a long time investor, I'm telling you the most important thing about these 2x and 3x ETF's is that basic math proves they will ALL eventually go to ZERO.

Watch :

Start : You buy FAZ @ 100
Day 1 : Financials go up 10 % - FAZ goes to 70
Day 2 : Market goes down 10 % = FAZ goes to 91 (1.30 * 70)
You have lost 10 percent yet the market has essentially gone nowhere.

Now just repeat those days again and again and FAZ goes to Zero EVEN THOUGH THE MARKET IS STILL IN THE SAME PLACE.

Or how about this:

Start : You buy FAZ @ 100
Day 1 : Financials go up 33 % - FAZ goes to 1

Your IRA is wiped out.

And finally, the odds of FAZ even hitting $40 again are infinitesimal. Basic math again - the biggest move up FAZ has EVER made is about 250% - that means, in the best case scenario, FAZ could go from $9 here to a max of $23 - IF you could even get lucky enough to make the same move.

Bill L.

I noticed you said you've moved a significant portion of your IRA to these instruments, and I'm sure you've done your research on these, but my first statement is be careful.

The basic sense is that these stocks degrade over time, regardless of the direction of the market, particularly over the longer period. Even after a share rises considerably, it still has a tendency to come crashing back down (The higher the price, the harder the fall).

My biggest point with these things is that they have a tendency to degrade over time (look at FAS and FAZ, both under 10 now, starting at around 40), and compound under either short term strong trends, or long term low volatility moves (think a longer term bull). However, high volatility can kill them, without the market going anywhere.

As an exercise, imagine that the stock market moved up 5% for three straight days, down 5 for three days, up for 5, and down for five one more time. In this case, the underlying stock would have moved -1.5%, while the triple levered bull ETF would have lost 12.8% (an 8x multiple, not 3x). Under high volatility these stocks degrade, even if the market does not really choose a direction. If you are right, congrats, but if you are wrong, or even if your timing is wrong, this could have a horrific impact on your IRA.

Personally, I've started to purchase about 30-40% OTM (out of the money) quasi straddles (puts on a 3x pair) and played it that way, because in this market, the first guarantee is large daily percentage moves, and large moves that you really don't expect. In those cases, the reward on these positions is great.

Bill L., http://www.evilspeculator.com.

Thank you, Bill, Matt and S. for the explanations and kind warnings. So as I understand it, extreme daily volatility acts like Kryptonite on these 3X and 2X ETFs, degrading their value in a one-way direction. That leads to the conclusion that they're best deployed as very short-term trading mechanisms in "Throwing Long" situations where you have high confidence in the trend (i.e. you just saw the cornerback slip, leaving your wide receiver open).

This degradation can be seen in the chart of the SRS, a Real Estate Bear 3X fund:

Having been duly warned of the high risks inherent to leveraged ETFs, I want to remind readers once again this is all the freely offered musings of an avowed amateur observer; please read the HUGE GIANT BIG FAT DISCLAIMER to clarify that this is NOT INVESTMENT ADVICE. If you want investment advice, locate a qualified professional and pay them for their services (after checking their track record and professional standing, of course. Caveat Emptor in all things.)

Now let's take a look at the 1X (that is, no leverage added) DOG ProShares Short Dow 30 for any evidence that the six-week uptrend is about to reverse into a downtrend:

To recall a key bit of the previous entry:

The single most powerful investment concept is that going against the trend destroys your wealth and riding with the trend increases your wealth.

So the question is: what evidence is there in the chart of DOG that the market uptrend (which because the DOG is an inverse/short/Bear ETF, appears as a huge decline) has lots of room to run?

Precious little, in my view, as MACD and Stochastic are both suggesting a change of trend is at hand. Those who follow volume have noted a decline in overall volume traded (a bad thing for a Bull uptrend) and those who follow investor sentiment have noted a substantial rise in investor euphoria/positive sentiment.

Contrarians believe those Bullish indicators mark market tops.

If things are looking up, why are company insiders rushing to sell, sell, sell their shares? That too usually marks tops, not bottoms.

Conclusion: those who believe a trend change is at hand have multiple ways to profit from the turn downward. These include options (puts), selling short, and the short ETFs (1x-unleveraged, and 2X and 3X-leveraged). Winning the game requires a long-haul strategy. In investing/speculating, the first key to a successful "game-winning" strategy is to get the trend right.

The second key is to be willing and able to modify your strategy if you get the trend wrong.

DISCLOSURE: As of the market close on Friday, April 17, I also own puts (options) on BAC (Bank of America) and KBH (KB Homes). 


Thank you to everyone who emailed me recently. My computer time has been very limited due to the intrusions of "real life" and so I remain behind in all digital work. Thank you for your patience and understanding. 

Thank you, Jeff S. ($10), for your much-appreciated generous contribution to this site. I am greatly honored by your support and readership.

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