Understanding Chinese Policymaking

Traders do not think like government officials.

My traders friends would enthusiastically agree.

They are smarter, faster, and even better-looking!

It is fine for us to think that we are smarter and wiser than those making government decisions.  Even if this is true, it may not help us when making predictions.

If we want to forecast the behavior of government, we need to take a different perspective.  Most market commentators think about China from a trading perspective.  Consider these two questions:

  1. Why does China continue to invest in US bonds?  The interest rate is small.  It is likely to rise leading to capital losses.  The dollar, despite recent strength, is in a secular decline.
  2. Why would China invest in Italian bonds?  They are risky.  It seems like there are strikes every day.  The CDS prices are rising.  The market is screaming the risk.

The Trader Perspective

The trader, putting himself in the role of the Chinese, has an easy answer to both questions.  The Chinese commitment to the US bond market is fragile and fleeting.  They could sell at any moment.  Who would then buy our bonds?  It is yet another example of the danger of  debt.

The Chinese would also be crazy to buy the bonds of Italy or any other European country.  There are much safer investments and others that provide a better return.

The Policymaking Perspective

The trader view is far too narrow.  On the first question it has been incorrect for many years.  The Chinese are more interested in economic development, creating employment, and selling products than the profits on their bond portfolio.  The US trade deficit is largely a function of the undervalued Chinese currency, an intentional policy on their part.

The Chinese also have a strong interest in worldwide economic strength and avoiding collapse in Europe.  The consequences of cascading defaults might cost them much more than possible losses on a bond investment.

Conclusion

If you want to predict what governments will do, you must think like a government official.  The trading perspective may be of little concern, a much lower priority.

The rumors of Chinese buying in Europe have been around for weeks.  I did not mention them in my weekly update yesterday, because the story was too thin.

Now that the rumor has been published,  it is worth evaluating.  The outcome is far from certain, and I make no predictions here.  The Chinese may get involved, but seek some other participants.

With this in mind, there are many parties with an interest in stabilizing Europe.  This concept has been widely neglected by pundits who choose the sexy story:  The death of the European Union and the related costs.

EU leaders may find the famous Mark Twain to be appropriate: 

The reports of my death are greatly exaggerated.

Apple, Event Risk, and Market Timing

Owning any stock involves risk.  Sometimes it is the risk of specific events.  Apple Computer, Inc.  (AAPL) is a good example.

The loss of Steve Jobs as CEO is obviously a negative for the stock.  He has been a visionary leader, and that has been recognized by the market.

Precisely what does his loss mean, and how should investors react?

Background

I have been very accurate about Apple, a big, multi-year winner for me.  I have written about it fairly often, most recently in July when I explained why people would probably miss big gains if they tried to trade around the 200-day moving average, then about 335.  I have about twenty other articles, mostly illustrating why it is better to own this stock on valuation rather than try to time the market.  Here is one from 2006, when the stock was trading about 60.

Apple is a good illustration of why earnings-based fundamental analysis pays off in the long run.  That is why I have written about it so often.

Two Perspectives

There are two different ways to think about Apple — the story and the data.

The Story

Many people focus on the drama, the product introductions and the human story.  This happens for many reasons, but here are the most important:

  • You can write many articles about products, reviews, and innovations.
  • Everyone is a (self-described) expert on these topics, so all can join in.
  • The stock is volatile, providing a lot of opportunity to draw charts and offer technical opinions.
  • The ever-present threat of losing Steve Jobs was itself a source of rumors and trading opportunities.

The Data

You could also focus on the data, the greatest growth story of our time.  Most people did not know how to analyze the stock correctly.  Here are three incorrect methods, all frequently cited by many pundits:

  • Take a PE ratio without adjusting for the cash on the books.
  • Do some Shiller-style ten-year, backward-looking method — guaranteed to make the company look expensive until it is too late to buy.
  • Try to apply Tobin's Q.  What do you suppose is the "replacement value" for Apple?

The Conclusion for Apple

Regular readers know that I endorse data over the "story,"  but let's try to pay attention to both.  Investors should have expected this.  I did my own research a year ago, verifying that the new product stream was not dependent upon Jobs.  As an investor, I knew that there would someday be bad news, but it was something to be expected.  There was no way to time this.  If you worried about the eventual bad news, you would have missed (at least) the last 100 points in the stock. 

The illustration of the differing perspectives comes from a timely and helpful discussion on CNBC.

From James Altucher we have the data.  "The stock trades for 12 times forward earnings, has 80 billion in cash, and 100% earnings growth.  Meanwhile, the platform is all there.  They are going to continue to sell iPads.  They are going to continue to sell iPhones…"

From Jon Fortt we have a good take on the story.  He does a very nice job of describing the special qualities of Jobs — in negotiating costs, making new deals, and getting the most from his team.  While he is important for innovation, that is not the whole story.  Fortt also notes that Tim Cook has some of these same qualities.

While there will be many stories tomorrow morning, this video captures the key elements to consider.

 

 

Investment and Market Implications

If you have been waiting for an entry point in Apple, you now have it.  There will also be market implications since AAPL is the largest stock in the S&P and the QQQ's.

The issue of "headline risk" is one that we must deal with every day.

Reading the headlines is guaranteed to send you to the sidelines.  Does that fit with your future?

 [long AAPL]

The Fed Decision and the Market Reaction

The morning papers will tell you that the Fed made a decision and the market rallied by 4%.  Causation will be implied, even when not explicitly stated.

For most of the punditry the interpretation of these stories is seen through the prism of their opinions.  Forget the data!

The initial reaction to the Fed decision — for a heartbeat — was a rally based upon the apparent promise to hold rates low until 2013.  Then the critical commentary hit.  I watch a good group of sources via Twitter as well as the MSM commentary.  The Twitterati had an immediate negative reaction.  It is a tough audience that usually hates Bernanke and the Fed.  As the market sold off, the comments became more strident.  There was criticism of Doug Kass, who turned out to be the star of the day.  He explicitly stated that the Fed decision was favorable for risk assets.  No one agreed.  Financial TV started raising questions, like whether or not the 2013 date was a firm promise.

Kass called the rally in real time, and most everyone disagreed.

When the market rallied, suddenly things changed.  New explanations were needed.  Even tonight's Kudlow show involved as many interpretations as there were guests.

Too Many Explanations, Too Little Knowledge

Anyone experienced in analyzing causal relationships knows the difficulty when you have multiple variables and few events.  You cannot invoke the right statistical controls.

A pundit test would be great fun.  The "expert" is given a set of facts and must then predict the market reaction without knowing the real outcome.  (Please note the relevance to last week's trading).  Let us consider yesterday's huge decline, widely attributed to the S&P debt downgrade.  There were a number of possible sources of selling:

  • The debt downgrade.  One would expect to see this reflected in higher interest rates, but rates moved lower.
  • The European crisis.  The ECB  bought bonds and the interest rates of Italy and Spain moved much lower.  Even those who did not see this as a complete solution had to be impressed by the result.
  • Margin calls on various market participants.  We do not have precise information on this, but I think it was important.
  • Momentum trading.  One of our programs is a momentum model, and it did very well — even signaling an exit late in the day.  While our technology is very good, others do similar things.

My own explanation includes all of the above, not a single cause.  The apparent anomaly on the downgrade requires a deeper look.  Between the Tea Party and the S&P, the market believes that the US must now focus on immediate deficit reduction.  I disagree — a story for another day — but that is the market perception.  I commented to my team that this idea would turn up somewhere, and sure enough, I see that David Rosenberg has that viewpoint.  It is one of the few good explanations of why bonds rallied on the downgrade while stocks tanked.

The Fed Decision

Let us now turn to today's action.  Let me start with my interpretation of the Fed move.  I am not going to do a detailed analysis, assuming that readers of "A Dash" have a basic understanding from primary sources.

  • The 2013 date is a promise, but not a contract.  The language is not definitive, but is open to interpretation.  I think that this is intentional.  The specified date is stronger than the "extended period" language, which implied two or three Fed meetings.  If the economy improves a lot, this is going to change.  Having said this, it will be difficult to revoke the promise without a major change in conditions.  Eventually market participants will come to this viewpoint.
  • The economic outlook was downgraded realisitically.  This was not the meeting to report a formal change in estimates, but obviously the change is there.  The Fed explicitly acknowledged the weaker data, even worse than the Japan/soft patch thesis would suggest.
  • The door is ajar on balance sheet management.  "The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate."  This is better than announcing a QE3 program.  Most market participants still do not understand QE2, including the fact that it has not ended.
  • The three dissents.  While this is still a 7-3 vote, it is far from the typical unanimity.  The dissenters seem to have a more bullish view on the economy, with less need for long-term action.  The bearish segment of the punditry will see the dissenters as fearing inflation without growth, so this is more fuel for the fire.
  • An air of mystery.  Other options were considered.  Who knows?  Pundits are already speculating about a QE3, with the Jackson Hole annual speech only weeks away.

The decision gives plenty of room for interpretation, helping to explain the market confusion.

Market Interpretation

Here are several other interpretations for the market rally:

  • Realizing that interest rates will be low for years to come, the comparison to dividend and earnings yields in stocks (the widest risk spread in history according to some) suggests the need to reconsider asset allocation.
  • The "attack on the yield curve" stimulated short covering in Treasuries, as well as stocks.
  • The market was oversold and ready for a rally unless the Fed decision was something horrible.
  • Many were caught leaning the wrong way, so there was massive short-covering.

No wonder my twitter friends were so far off base.  Since the actual decision was not that dramatic, I favor a combination of the above causes.

Investment Implications

It is a mistake for the average investor to attempt to time these moves in a volatile market.  Having a price target for individual stocks that you want to own makes much more sense.