The Big Picture

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• Sir John Templeton 16 Rules For Investment Success
• What’s It Like to Start a Hedge Fund?
• Durable Orders Potential Recession Warning, WSJ Intellectual Dishonesty (Again)
• Tuned: 535hp BMW M3 Monticello Motorpark
• 10 Weekend Reads
• The Emerging Headache of QE3

Sir John Templeton 16 Rules For Investment Success Posted: 29 Sep 2012 11:00 AM PDT Interesting set of rules from legendary investor John Templeton: 1. Invest for maximum total real return 2. Invest — Don’t trade or speculate 3. Remain flexible and open minded about types of investment 4. Buy Low 5. When buying stocks, search for bargains among quality stocks. 6. Buy value, not market trends or the economic outlook 7. Diversify. In stocks and bonds, as in much else, there is safety in numbers 8. Do your homework or hire wise experts to help you 9. Aggressively monitor your investments 10. Don’t Panic 11. Learn from your mistakes 12. Begin with a Prayer 13. Outperforming the market is a difficult task 14. An investor who has all the answers doesn’t even understand all the questions 15. There’s no free lunch 16. Do not be fearful or negative too often   Complete explanation after the jump     No. 1 INVEST FOR MAXIMUM TOTAL REAL RETURN This means the return on invested dollars after taxes and after inflation. This is the only rational objective for most long-term investors. Any investment strategy that fails to recognize the insidious effect of taxes and inflation fails to recognize the true nature of the investment environment and thus is severely handicapped. It is vital that you protect purchasing power. One of the biggest mistakes people make is putting too much money into fixed-income securities. Today's dollar buys only what 35 cents bought in the mid 1970s, what 21 cents bought in 1960, and what 15 cents bought after World War II. U.S. consumer prices have risen every one of the last 38 years. If inflation averages 4%, it will reduce the buying power of a $100,000 portfolio to $68,000 in just 10 years. In other words, to maintain the same buying power, that portfolio would have to grow to $147,000— a 47% gain simply to remain even over a decade. And this doesn't even count taxes. No. 2 INVEST—DON'T TRADE OR SPECULATE The stock market is not a casino, but if you move in and out of stocks every time they move a point or two, or if you continually sell short… or deal only in options…or trade in futures…the market will be your casino. And, like most gamblers, you may lose eventually—or frequently. You may find your profits consumed by commissions. You may find a market you expected to turn down turning up—and up, and up—in defiance of all your careful calculations and short sales. Every time a Wall Street news announcer says, "This just in," your heart will stop. Keep in mind the wise words of Lucien Hooper, a Wall Street legend: "What always impresses me," he wrote,"is how much better the relaxed, long-term owners of stock do with their portfolios than the traders do with their switching of inventory. The relaxed investor is usually better informed and more understanding of essential values; he is more patient and less emotional; he pays smaller capital gains taxes; he does not incur unnecessary brokerage commissions; and he avoids behaving like Cassius by 'thinking too much.'" No.3 REMAIN FLEXIBLE AND OPEN-MINDED ABOUT TYPES OF INVESTMENT There are times to buy blue chip stocks, cyclical stocks, corporate bonds, U.S. Treasury instruments, and so on. And there are times to sit on cash, because sometimes cash enables you to take advantage of investment opportunities. The fact is there is no one kind of investment that is always best. If a particular industry or type of security becomes popular with investors, that popularity will always prove temporary and—when lost—may not return for many years. Having said that, I should note that, for most of the time, most of our clients' money has been in common stocks. A look at history will show why. From January of 1946 through June of 1991, the Dow Jones Industrial Average rose by 11.4% average annually—including reinvestment of dividends but not counting taxes—compared with an average annual inflation rate of 4.4%. Had the Dow merely kept pace with inflation, it would be around 1,400 right now instead of over 3,000, a figure that seemed extreme to some 10 years ago, when I calculated that it was a very realistic possibility on the horizon. Look also at the Standard and Poor's (S&P) Index of 500 stocks. From the start of the 1950s through the end of the 1980s—four decades altogether—the S&P 500 rose at an average rate of 12.5%, compared with 4.3% for inflation, 4.8% for U.S. Treasury bonds, 5.2% for Treasury bills, and 5.4% for high-grade corporate bonds. In fact, the S&P 500 outperformed inflation, Treasury bills, and corporate bonds in every decade except the '70s, and it outperformed Treasury bonds—supposedly the safest of all investments—in all four decades. I repeat: There is no real safety without preserving purchasing power. No. 4 BUY LOW Of course, you say, that's obvious. Well, it may be, but that isn't the way the market works. When prices are high, a lot of investors are buying a lot of stocks. Prices are low when demand is low. Investors have pulled back, people are discouraged and pessimistic. When almost everyone is pessimistic at the same time, the entire market collapses. More often, just stocks in particular fields fall. Industries such as automaking and casualty insurance go through regular cycles. Sometimes stocks of companies like the thrift institutions or money-center banks fall out of favor all at once. Whatever the reason, investors are on the sidelines, sitting on their wallets. Yes, they tell you: "Buy low, sell high." But all too many of them bought high and sold low. Then you ask: "When will you buy the stock?" The usual answer: "Why, after analysts agree on a favorable outlook." This is foolish, but it is human nature. It is extremely difficult to go against the crowd—to buy when everyone else is selling or has sold, to buy when things look darkest, to buy when so many experts are telling you that stocks in general, or in this particular industry, or even in this particular company, are risky right now. But, if you buy the same securities everyone else is buying, you will have the same results as everyone else. By definition, you can't outperform the market if you buy the market. And chances are if you buy what everyone is buying you will do so only after it is already overpriced. Heed the words of the great pioneer of stock analysis Benjamin Graham: "Buy when most people…including experts…are pessimistic, and sell when they are actively optimistic." Bernard Baruch, advisor to presidents, was even more succinct: "Never follow the crowd." So simple in concept. So difficult in execution. No. 5 WHEN BUYING STOCKS, SEARCH FOR BARGAINS AMONG QUALITY STOCKS Quality is a company strongly entrenched as the sales leader in a growing market. Quality is a company that's the technological leader in a field that depends on technical innovation. Quality is a strong management team with a proven track record. Quality is a well-capitalized company that is among the first into a new market. Quality is a wellknown trusted brand for a high-profit-margin consumer product. Naturally, you cannot consider these attributes of quality in isolation. A company may be the low-cost producer, for example, but it is not a quality stock if its product line is falling out of favor with customers. Likewise, being the technological leader in a technological field means little without adequate capitalization for expansion and marketing. Determining quality in a stock is like reviewing a restaurant. You don't expect it to be 100% perfect, but before it gets three or four stars you want it to be superior. No. 6 BUY VALUE, NOT MARKET TRENDS OR THE ECONOMIC OUTLOOK A wise investor knows that the stock market is really a market of stocks. While individual stocks may be pulled along momentarily by a strong bull market, ultimately it is the individual stocks that determine the market, not vice versa. All too many investors focus on the market trend or economic outlook. But individual stocks can rise in a bear market and fall in a bull market. The stock market and the economy do not always march in lock step. Bear markets do not always coincide with recessions, and an overall decline in corporate earnings does not always cause a simultaneous decline in stock prices. So buy individual stocks, not the market trend or economic outlook. No. 7 DIVERSIFY. IN STOCKS AND BONDS, AS IN MUCH ELSE, THERE IS SAFETY IN NUMBERS No matter how careful you are, you can neither predict nor control the future. A hurricane or earthquake, a strike at a supplier, an unexpected technological advance by a competitor, or a government-ordered product recall—any one of these can cost a company millions of dollars. Then, too, what looked like such a well-managed company may turn out to have serious internal problems that weren't apparent when you bought the stock. So you diversify—by industry, by risk, and by country. For example, if you search worldwide, you will find more bargains— and possibly better bargains—than in any single nation. No. 8 DO YOUR HOMEWORK OR HIRE WISE EXPERTS TO HELP YOU People will tell you: Investigate before you invest. Listen to them. Study companies to learn what makes them successful. Remember, in most instances, you are buying either earnings or assets. In free-enterprise nations, earnings and assets together are major influences on the price of most stocks. The earnings on stock market indexes—the fabled Dow Jones Industrials,for example—fluctuate around the replacement book value of the shares of the index. (That's the money it would take to replace the assets of the companies making up the index at today's costs.) If you expect a company to grow and prosper, you are buying future earnings. You expect that earnings will go up, and because most stocks are valued on future earnings, you can expect the stock price may rise also. If you expect a company to be acquired or dissolved at a premium over its market price, you may be buying assets. Years ago Forbes regularly published lists of these so-called "loaded laggards." But remember, there are far fewer of these companies today. Raiders have swept through the marketplace over the past 10 to 15 years: Be very suspicious of what they left behind. No. 9 AGGRESSIVELY MONITOR YOUR INVESTMENTS Expect and react to change. No bull market is permanent. No bear market is permanent. And there are no stocks that you can buy and forget. The pace of change is too great. Being relaxed, as Hooper advised, doesn't mean being complacent. Consider, for example, just the 30 issues that comprise the Dow Jones Industrials. From 1978 through 1990, one of every three issues changed—because the company was in decline, or was acquired, or went private, or went bankrupt. Look at the 100 largest industrials on Fortune magazine's list. In just seven years, 1983 through 1990, 30 dropped off the list. They merged with another giant company, or became too small for the top 100, or were acquired by a foreign company, or went private, or went out of business. Remember, no investment is forever. No.10 DON'T PANIC Sometimes you won't have sold when everyone else is buying, and you'll be caught in a market crash such as we had in 1987. There you are, facing a 15% loss in a single day. Maybe more. Don't rush to sell the next day. The time to sell is before the crash, not after. Instead, study your portfolio. If you didn't own these stocks now, would you buy them after the market crash? Chances are you would. So the only reason to sell them now is to buy other, more attractive stocks. If you can't find more attractive stocks, hold on to what you have. No. 11 LEARN FROM YOUR MISTAKES The only way to avoid mistakes is not to invest—which is the biggest mistake of all. So forgive yourself for your errors. Don't become discouraged, and certainly don't try to recoup your losses by taking bigger risks. Instead, turn each mistake into a learning experience. Determine exactly what went wrong and how you can avoid the same mistake in the future. The investor who says, "This time is different," when in fact it's virtually a repeat of an earlier situation, has uttered among the four most costly words in the annals of investing. The big difference between those who are successful and those who are not is that successful people learn from their mistakes and the mistakes of others. No. 12 BEGIN WITH A PRAYER If you begin with a prayer, you can think more clearly and make fewer mistakes. No.13 OUTPERFORMING THE MARKET IS A DIFFICULT TASK The challenge is not simply making better investment decisions than the average investor. The real challenge is making investment decisions that are better than those of the professionals who manage the big institutions. Remember, the unmanaged market indexes such as the S&P 500 don't pay commissions to buy and sell stock. They don't pay salaries to securities analysts or portfolio managers. And, unlike the unmanaged indexes, investment companies are never 100% invested, because they need to have cash on hand to redeem shares. So any investment company that consistently outperforms the market is actually doing a much better job than you might think. And if it not only consistently outperforms the market, but does so by a significant degree, it is doing a superb job. No. 14 AN INVESTOR WHO HAS ALL THE ANSWERS DOESN'T EVEN UNDERSTAND ALL THE QUESTIONS A cocksure approach to investing will lead, probably sooner than later, to disappointment if not outright disaster. Even if we can identify an unchanging handful of investing principles, we cannot apply these rules to an unchanging universe of investments—or an unchanging economic and political environment. Everything is in a constant state of change, and the wise investor recognizes that success is a process of continually seeking answers to new questions. No.15 THERE'S NO FREE LUNCH This principle covers an endless list of admonitions. Never invest on sentiment. The company that gave you your first job, or built the first car you ever owned, or sponsored a favorite television show of long ago may be a fine company. But that doesn't mean its stock is a fine investment. Even if the corporation is truly excellent, prices of its shares may be too high. Never invest in an initial public offering (IPO) to "save" the commission. That commission is built into the price of the stock—a reason why most new stocks decline in value after the offering. This does not mean you should never buy an IPO. Never invest solely on a tip. Why, that's obvious, you might say. It is. But you would be surprised how many investors, people who are well-educated and successful, do exactly this. Unfortunately, there is something psychologically compelling about a tip. Its very nature suggests inside information, a way to turn a fast profit. No. 16 DO NOT BE FEARFUL OR NEGATIVE TOO OFTEN And now the last principle. Do not be fearful or negative too often. For 100 years optimists have carried the day in U.S. stocks. Even in the dark '70s, many professional money managers—and many individual investors too—made money in stocks, especially those of smaller companies. There will, of course, be corrections, perhaps even crashes. But, over time, our studies indicate stocks do go up…and up… and up. With the fall of communism and the sharply reduced threat of nuclear war, it appears that the U.S. and some form of an economically united Europe may be about to enter the most glorious period in their history. As national economies become more integrated and interdependent, as communication becomes easier and cheaper, business is likely to boom. Trade and travel will grow. Wealth will increase. And stock prices should rise accordingly. By the time the 21st century begins—it's just around the corner, you know—I think there is at least an even chance that the Dow Jones Industrials may have reached 6,000, perhaps more. Chances are that certain other indexes will have grown even more. Despite all the current gloom about the economy, and about the future, more people will have more money than ever before in history. And much of it will be invested in stocks. And throughout this wonderful time, the basic rules of building wealth by investing in stocks will hold true. In this century or the next it's still "Buy low, sell high."     Source: BY SIR JOHN TEMPLETON Franklin Templeton Ivestments

What’s It Like to Start a Hedge Fund? Posted: 29 Sep 2012 09:32 AM PDT Prosiris Capital Management’s Founder and CIO Reza Ali talks about starting a hedge fund and his investment strategy. He speaks on Bloomberg Television’s “Money Moves.” Source: Bloomberg

Durable Orders Potential Recession Warning, WSJ Intellectual Dishonesty (Again) Posted: 29 Sep 2012 08:00 AM PDT Invictus (@TBPInvictus) here with a few random observations for your Saturday enjoyment while you sip your second cup of java. ~~~~ If you’re a subscriber to David Rosenberg’s Breakfast With Dave, you might have seen the chart below, which I posted Thursday on Twitter, in Friday’s note (share and share alike, I always say):     A break of this magnitude in Durables – that’s ex-aircraft – has in the past been a harbinger of of recession and a downturn in payrolls (I’ve used private payrolls, excluding government). BR laid out a similar warning on decaying economic conditions yesterday, offset only by the strength of monetary policies. Two caveats on this: Durable Goods has a history (at least on FRED) limited to about 20 years, so we don’t have a lot of data. We did see a false positive in the period around 1999 or so. On a related note, business activity fell into contractionary territory (ISM-Chicago, grey bars) for the first time in three years:     Another revision to GDP (down to 1.3 percent) was released on Thursday, and I note the following: Government spending has been a drag on GDP for what I believe is a record eight consecutive quarters:   For better (govt contributes to) or worse (govt detracts from), government is part of the GDP equation. One of the reasons we’ve gotten a string of crappy GDP prints is the fact that government continues to be a drag. This is indisputable. We can debate and discuss the appropriate role of government, but we cannot deny that it’s been a drag on GDP for the past two years. Again – and this is not my first go-round on this type of intellectual dishonesty – the WSJ recently ran a misleading chart which was, not surprisingly, the work of the Heritage Foundation:   Misleading & Intellectually Dishonest Chart, from WSJ OpEd via Heritage   Note to the Journal (and Heritage): We measure recessions from economic peaks and recoveries from economic troughs (as determined by the NBER). This is not controversial. When you claim this is “the slowest recovery since the 1960s” while pegging your chart to the period “before the recession began 55 months ago,” you are (deliberately) misleading your (ever-dwindling) readership, just as you were the first time I called you out on it 18 months ago. Perhaps in the future, you can find a better model of economic analysis than Niall Ferguson. The fact, as I’ve repeatedly demonstrated, is that this is not the slowest jobs recovery since the 1960s. In fact, the last jobs recovery was slower than this one:   (Source: FRED, USPRIV series, indexed to 100 at November 2001 and June 2009)   Here’s what an honest chart would look like (not much chance we’ll be seeing this anytime soon from the Journal). Note in terms of private sector job creation — one of the WSJ’s favorite recovery metrics — the present post credit crisis recovery is mediocre, but hardly the worst in post war history. In fact, its better than even the so-called Bush Boom which the Journal used to be so found of touting.   An Intellectually Honest Look at Private Payrolls During Recoveries I’m sure I’ll be addressing this issue again in the not-too-distant future. Sadly, while misinformation like this is SOP for Heritage, it’s been disappointing to watch the Journal – once a top-flight publication – slowly lose its credibility under the Murdoch empire umbrella. To conflate “recession” and “recovery” – to use them interchangeably – takes either monumental ignorance of economic terms or a deliberate desire to mislead. Neither holds the Journal in particularly good stead.   Previously: Attention WSJ OpEd: Correction Needed, April 2011 It Was the Best of Times. It Was the Worst of Times. Yup., Sept. 2010

Tuned: 535hp BMW M3 Monticello Motorpark Posted: 29 Sep 2012 05:00 AM PDT Tuned goes to Monticello Motor Club to visit the Turner Motorsport race team, who have brought us two cars: Their 535-horsepower, all-motor Frozen M3 street project car, and the 2011 Continental Tire Series Championship-winning E92 M3 Race Car driven by Bill Auberlin and Paul Dalla Lana. We learn the importance of having your street car tuned by a company that goes out and wins races every weekend, and that on the track, horsepower is far from everything. Turner Motorsport’s 535 hp Frozen Gray BMW M3 and Championship

10 Weekend Reads Posted: 29 Sep 2012 04:45 AM PDT Some longer form articles to start your weekend: • How Bernanke Pulled the Fed His Way (WSJ) • The Marketplace in Your Brain (Chronicle) • Meredith Whitney Blew a Call—And Then Some (WSJ)  Meredith Whitney would have made a terrific replacement referee • A Case Shiller two-fer: …..-Shiller: Data Questions Housing Revival Power: Cutting Research (Bloomberg) …..-Case: Home Prices Unlikely to Come 'Roaring' Back (Bloomberg) • The new great stem cell dilemma: how to make the business work (Fortune) • Startup = Growth (Paul Graham) • Rhythm in Disguise: Musical therapists (The Morning News) • Anti-Intellectualism in American Life (Review B&N) • Glass Works: How Corning Created the Ultrathin, Ultrastrong Material of the Future (Wired) • “The Best TV Show That’s Ever Been” (GQ) What’s on your tablet?   QE Chatter and Equities Source: WSJ

The Emerging Headache of QE3 Posted: 29 Sep 2012 03:00 AM PDT The Emerging Headache of QE3 Andy Xie Caixin Online, 09.24.2012       The Fed’s latest quantitative easing may cause problems for countries grappling with inflation and should prompt China to press ahead with economic reforms The Fed has promised to purchase US$ 40 billion worth of mortgage-backed securities (MBS) per month until it is satisfied with the economy. By all accounts an unemployment rate above 7 percent is not satisfactory to the Fed. Its own analysis doesn’t expect the unemployment rate to fall below 7 percent in two years. That suggests that QE3 will last for over two years, and the total amount of MBS purchases will exceed $1 trillion, more than QE1′s US$ 1 trillion. Through its purchases of MBS, the Fed provides direct support to the housing market and banks. The housing market is still wobbly. No economic recovery can be strong without a strong housing market. The Fed’s purchases will narrow the spread between the treasury yield and housing financing cost. The 10-year treasury yield is 1.8 percent. If the mortgage interest rate is decreased to such a level, it provides ample refinancing opportunity, which alleviates the debt burden for the heavily indebted household sector. The United States’ household sector is US$ 12.9 trillion in debt, down nearly US$ 1 trillion from the peak, partly through bankruptcies. The pressure for reducing the debt is considerable. It is a major factor in keeping the economy weak. Through decreasing the interest burden, QE3 is likely to lessen the deleveraging pressure. The United States’ household real estate value has declined by 30 percent from the peak in 2006. The current aggregate value of US$ 16 trillion is slightly above 100 percent of GDP and still high by historical standards. If the market adjusts naturally, it may well fall another 30 percent. The Fed’s actions so far have decreased its decline. QE3 is likely to continue this support. However, the artificial support can’t reverse the trend. It merely allows the nominal GDP to grow while keeping housing value stable. It cushions the downturn, but also saps the recovery strength. The Fed is unhappy with the strength of the economic recovery. It has itself to blame. The monetary and fiscal stimulus prevented a thorough cleansing of the inefficient economic activities that built up during the bubble economy. The economy didn’t reach its natural bottom in the downturn. Therefore, the upturn is weak too. Many unproductive economic activities still take up a significant chunk of resources. Finance and health care, in particular, are still highly inefficient and take up nearly one-fourth of the economy. The Fed’s monetary policy cannot substitute for structural reforms. QE3 will not create a strong economy. Stagflation in Emerging Economies In anticipation of QE3, commodity prices, especially oil and agricultural commodities, have surged. The most direct path from QE to inflation is through commodities. This inflation angle hits emerging economies and low-income people hard. The share of commodities in the consumption basket declines with income. Hence, developed economies are less affected than emerging economies when the prices of commodities rise. Emerging economies already suffer from slowing growth and sticky inflation. QE3 may force emerging economies to tighten their monetary policy despite weakening growth. In the inflation calculation, the U.S. economy comes out ahead of others. Its natural gas price is exceptionally low due to the shale gas boom. Its economy is shifting to gas from oil. Hence, it suffers much less from rising oil prices than during QE1. The United States is a net exporter of agricultural commodities. While there is an internal distribution issue, the United States as a whole benefits from food inflation. Because it is less inflation prone and benefits from inflation as a whole, the Fed won’t waver on QE3 despite inflation rising around the world. During QE1 there was a huge wave of hot money flowing into emerging economies. There was only a trickle during QE2. Hot money is unlikely to be significant during QE3. The reason is bad fundamentals in emerging economies. The QE1 hot money created a huge bubble in emerging economies. It has weakened the fundamentals there. Inflation, bad loans and a deflating property bubble are afflicting emerging economies. Hot money does not flow to sick economies. The emerging economies are already in a stagflationary situation. QE3 is pushing them further in that direction. The stock markets in emerging economies have performed poorly relative to the United States’. This divergence will likely continue during QE3. Indeed, the relative underperformance of emerging market stocks may escalate capital outflow in emerging economies, triggering financial crises like in 1998. Escalating Protectionism The Obama administration is filing a complaint against China at the WTO over autos and auto part subsidies. That action is obviously part of presidential election politics. Even though the administration can claim credit for saving General Motors, employment in the industry is considerably lower than a decade ago, partly due to import competition. The Obama camp wants to preempt the Romney side on this issue. The irony is that, while the Obama administration claims credit for saving GM, China actually did. GM sold 2.5 million vehicles in China in 2011. Moreover, these cars were sold at high prices. China probably has accounted for over 100 percent of GM’s profits over the past five years, i.e., it is losing money elsewhere. While the auto example seems purely political, protectionism is likely to rise and soon. QE3 may increase demand in the United States, especially for housing related goods. However, the demand is likely to be met with imports, mainly from China. In addition, China is suffering from overcapacity in most industries. An export push is quite likely. The reactions in Europe and the United States would be very negative. Multinational companies have led globalization, as they can influence politics in the demand countries. The debt crises of the past years are changing politics in Western economies. Corporate influence is waning as a result. Protectionism may follow. Amplifying Uncertainty The Fed has been complaining that the corporate sector, while sitting on record levels of cash, is not investing as much as it should. Hence, the employment situation doesn’t improve as much it could, which keeps demand weak and justifies the cautious investment attitude. The Fed believes that this “vicious” cycle can be broken through its policy. A major goal of QE3 is to convincing the corporate sector that the Fed will deliver a good economy through unlimited QE. If the corporate sector believes that the Fed will succeed, it should invest now, which would create a virtuous cycle. QE3 is partly a confidence trick; if the market believes, it is self-fulfilling. I doubt that the Fed will succeed in the confidence trick. QE creates its own uncertainty. Ben Bernanke is a follower of Milton Friedman, who famously remarked: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” The Fed reassures us that, when inflation becomes a problem, it will take back the excess money to stop it. However, such an act would trigger a massive recession. The promise may not be credible, i.e., the Fed may accommodate it and let all the QE money become inflation. The binary nature of the QE eventuality is a huge uncertainty. Keeping cash may be the best choice for businesses. Even though the investment process may create a virtuous cycle, it may not last. The Fed’s subsequent tightening could cause a massive recession and losses for businesses stuck with overcapacity. Hence, it doesn’t make sense to invest even though business could be good in the short term. Financial investors are responding to the uncertainty in extreme fashion. Some are holding bonds despite near zero interest rates because they believe that the Fed would crack down on inflation. Some are holding gold to hedge against the scenario that the Fed would accommodate. Hence, the gold price screams inflation, while bond prices say deflation. Such extreme and opposed views among investors cannot be good for the global economy. Inflating Bubble The Fed’s QE has already created a bubbly situation in Internet stocks. Private equity is another QE-related bubble. Agricultural commodities could become a big bubble this time. The global economy remains weak. QE3 won’t change that. Hence, industrial commodities are unlikely to become a bubble again. Indeed, industrial commodities may continue to deflate. For example, I think that the iron ore price could fall to US$ 50 per ton from a recent high of US$ 190. The spike in copper prices may not last either. The price of oil can go higher, as Saudi Arabia controls all the excess capacity and won’t increase production even if price goes up another 20 percent. The price of gold may go very high this time. QE3 is like a river. The flow may be small for any given day, but it adds up over time. As competing commodities cannot inflate due to weak demand and oversupply, the liquidity into gold could be far bigger than in QE1 and QE2. If agricultural commodities become a bubble this time, which I think is likely, it could trigger global political crises. The effect of QE1 on food prices was an important factor in triggering the Jasmine Revolutions in the Middle East. QE3 has the potential to propel food prices to even higher levels. The fundamentals in the emerging economies are worse than during QE1. High food prices will have bigger impact also. If food riots occur in Africa and South Asia, the Fed is partly to blame. China and Reform The continuing outperformance of the U.S. stock market may increase China’s capital outflow. If the U.S. property market begins to rise again, the outflow may become a torrent, triggering a banking crisis in China. There is an urgency for China to become more attractive for international and domestic capital. The returns on capital in China are very low and getting lower. Measures to boost GDP won’t change the situation. In the past five years, land appreciation has been the main source of profit. This bubble economy is deflating. The property market in tier-three cities has virtually crashed. The situation is spreading to tier-two cities. The suspension of property construction, due to collapsing sales, is the main factor in China’s economic weakness now. There are many efforts by the government and property industry to cover up the situation. Such efforts are surely to backfire. China urgently needs to cut taxes to improve demand and increase the effective returns on capital. It is possible that the United States will eventually boom with capital redistributing from China to it. The economies of China and the United States may move in opposite directions. Who goes up depends on relative attractiveness. If China doesn’t want to suffer a crisis, it must reform and become more attractive than the United States.   Source: The Emerging Headache of QE3 The Fed’s latest quantitative easing may cause problems for countries grappling with inflation and should prompt China to press ahead with economic reforms By Andy Xie Caixin Online, 09.24.2012 11:36

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