A REAL STATISTICAL RECOVERY

by John Mauldin

The following is an excerpt of John Mauldin’s weekly letter (see his full letter here):

The Recent GDP Numbers – A Real Statistical Recovery

Now, before we get into our panel discussion (and the meeting afterward), let me comment on the GDP number that came in yesterday. This is what Moody’s Analytics told us:

“Real GDP grew 3.2% at an annualized pace in the fourth quarter of 2010. This was below the consensus estimate for 3.6% growth and was an improvement from the 2.6% pace in the third quarter. Private inventories were an enormous drag on growth, subtracting 3.7 percentage points; this bodes very well for the near-term outlook and means that current demand is very strong. Consumer spending, investment and trade were all positives for growth in the fourth quarter; government was a slight negative. The economy will see very strong growth in 2011 as the tax and spending deal passed in December stimulates demand and the labor market picks up, creating a self-sustaining expansion.”

This 3.2% followed a 1.7% in the second quarter and a 2.6% in the third quarter. The trend is your friend.

Well, maybe not so much. That inventory number seemed odd to me, and looking into it with Lacy Hunt, it turns out there is more than the headline number. For some of you, this is going to be a little like “inside baseball;” but the way they calculate the GDP number can have some odd effects every now and then. And this quarter the effect was way more than normal. This is going to be somewhat counterintuitive, but hang in there with me as I try to make it simple.

You remember our old friendly equation:

GDP = C + I + G + (Net Exports) or

Gross Domestic Product is the combination of domestic Consumption (both consumer and business) plus Investments plus Government Expenditure plus Net Exports (exports minus imports). This latter category has been negative for quite some time, as imports, especially oil, have been larger than exports.

Now to get Real GDP (actual GDP after inflation) you have to take away the effects of inflation/deflation. This is done by the use of a deflator built in for each category. But the deflator for exports/imports is a little tricky at times.

Moody’s correctly noted that “private inventories were an enormous drag on growth” and concluded that this was a good thing, in that they assumed that meant inventories went down and thus inventory rebuilding in future quarters will add to GDP growth. And that is where you have to look at the numbers, and there we find our anomaly. There really wasn’t that big a drop in inventories. It was in large part in the statistics, not in the warehouse.

Oil in the 4^th quarter rose from roughly $81 to $89, or about 10%. On an annualized basis, this is 40%. Inventory investment is equal to the change in book value of the inventories, minus what is known as the IVA, or inventory valuation adjustment, which is used to correct for prices going up or down. Because the value of oil rose and thus cost more to acquire, the accounting requires that you reduce the value of the current inventories. Thus “real” imports fell at a 13% annual rate. Why? Because the deflator rose by 19%, largely because of the rise in the price of oil.

I know, I know, I just wrote that because the price of oil went up, the “real” value of imports went down, as well as inventories. Some of you are getting economic whiplash right about now.

If oil were to go back down this quarter by the same amount, that “growth” could be wiped out. There is no conspiracy here. It is just a statistical necessity, like hedonic measurements, and it is all very clear in the fine print; but when there are wide swings in oil prices over a quarter, and because our imports of oil are so large, you can get these odd accounting factoids. Which the gunslingers on TV (and elsewhere) miss in their urge to be the first to get out a bullish statement!

How much did it change things? Lacy thinks by anywhere from 0.5% to 1%. That means GDP is still a positive number, but there is not a “3” handle at the beginning of it. In the grand scheme of things, no big deal, as it will balance out over the coming quarters and years. But I just wanted to point out (once again) that you have to take some of the numbers we get from our government with a few grains of salt. That’s the key takeaway here. And they CERTAINLY should not be traded upon. (Anybody who trades on the employment numbers deserves what they get, which is usually a loss. But back to our story.)

Consumer Spending Rose? Where Was the Income?

The really surprising number you saw the talking heads on TV mention was the growth of consumer spending, at 4.4%. Is the US consumer back? After all, real final sales rose by 7.1%, a number not seen since 1984 and Ronald Reagan. But real income rose a paltry 1.7%. Where did the money that was spent come from? Savings dropped a rather large 0.5% for the quarter. That was part of it. And I can’t find the link, but there was an unusual drawdown of money market and investment accounts last quarter, somewhere around 1.5%, if I remember correctly. (David Walker remembered that article as well.) That would just about cover it. But that is not a good thing and is certainly not sustainable.

Let’s see what good friend David Rosenberg (more on Rosie below) has to say about those numbers:

“Even with the Q4 bounce, real final sales have managed to eke out a barely more than 2% annual gain since the recession ended, whereas what is normal at this stage of the cycle is a trend much closer to 4%. Welcome to the new normal [..]

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Try A Long Trade On Euro Bund

Continuano le divergenze positive sull'Euro Bund, in questo caso accompagnata da una figura rialzista a livello di barra giornaliera. A queste condizioni si può provare un Long con rigido Stop Loss sotto il minimo di venerdì scorso. 

Even a positive divergence on Euro bund, in this case accompanied by a bullish daily bar. We can try a Buy Long trade with rigorous stop below the low of last Friday.

Try A Short Trade On Sugar

Continuano le divergenze negative sul Sugar scadenza Maggio, in questo caso accompagnata da una figura ribassista a livello di barra giornaliera. A queste condizioni si può provare uno Short con rigido Stop Loss sopra il massimo di venerdì scorso.

Even a negative divergence on May Sugar, in this case accompanied by a bearish daily bar. We can try a sell short trade with rigorous stop loss above the high of last Friday.

Marine Diamond Mining

By Leia Michele Toovey
Pioneered by Sam Collins, marine diamond mining began in the 1960s off the coast of southern Namibia. The first marine diamond mining technique was an archaic dredging system; however, despite the simplicity of this original technique, Mr. Collins was able to recover around 788,000 carats of diamonds. In the years since, a handful of players, particularly De Beers, have sunk money and research into marine diamond mining. The result was a new exploration method that produced 1 million carats of diamonds in 2009.

Marine diamond mining takes place primarily along the 1,400 km stretch of coastline of southern Namibia and northwestern South Africa. Namibia has the richest known marine diamond deposits in the world, estimated at over 100 million carats. The marine diamonds were transported to the coastline over a roughly 100 million year time period. All of the diamond deposits in Namibia originate from kimberlites in South Africa. These diamonds were washed down the Orange River, and deposited at the river mouth as well as along the coastlines of Namibia and South Africa.

Despite the early successes of Mr. Collins and other entrepreneurial explorers, marine diamond mining has only gathered major interest over the last 15 years due to the unavailability of proper technology that would enable the miners to embark upon the large-scale mining operations necessary to turn a profit in this expensive endeavor. Also, the relatively low prices of diamonds at that time made the undertaking economically unfeasible.

Things started to change in 1970 when De Beers bought out existing marine operations along the Namibian/South African Coast and embarked upon a widespread exploration program. De Beers did not get immediate gratification;wasn't until the late 1980s that they were able to commission mining vessels and commence offshore diamond mining.

The two primary marine mining methods used by De Beers are the horizontal system, and the vertical system. In the horizontal system a seabed crawler brings diamond-bearing gravels to the vessel through flexible slurry hoses. In the vertical system, a large-diameter drilling device mounted on a compensated steel pipe drill string recovers diamond-bearing gravels from the seabed following a systematic pattern over the mining block. The De Beers Marine fleet consists of five mining vessels and one evaluation sampling and mining vessel. Mining takes place on the ocean floor at water depths ranging from 90 to 140 meters.  The rehabilitation of marine mining environments occur naturally, once the mining has been completed in a particular area.

Marine diamond mining has overtaken land mining in terms of carats produced, as land-based mines have seen a recent decline.  De Beers reported that in 2009, marine-mined diamonds accounted for around 60 percent of total diamond output from all their Namibia based mines.

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How John Paulson Made $5 Billion Last Year

by Robert Lenzner

The secret to the spectacular returns  Paulson  and his employees  reported for 2010 is due to their keeping  much of their money- $14.9 billion or 42% of the total assets under management($35 billion)– in the funds. That’s called putting your money to work alongside your clients. That $14.9 billion commitment is revealed in Paulson’s yearend letter to investors.
Some of Paulson’s personal share  in his funds must come from the $4 billion he made going short against the subprime mortgage bubble in 2007.
The Paulson funds  made gross gains in 2010 of $8.4 billion before fees.  So, 42% (their share)  of  the $8.4 billion meant $3.5 billion in gains for Paulson and his employees.
Add to that a 2% fee on $35 billion of capital– $700 million– and then the 20% fee on the total profits made adds another $1.7 billion to the pot shared by Paulson and his team.
By my figuring then, the total take comes to roughly $6 billion before  taxes.
Overall, the fund’s strategy made a transition during the year from a short equity bias  with a focus on being long distressed securities to a long equity event focus, according to Paulson’s yearend letter.
This growing  bullishness on the stock market  is due to  Paulson’s careful  tracking of  the equity risk premium measured by J.P. Morgan; the difference between the yield on equities and the yield on bonds. Paulson  is a buyer of stocks because he sees the equity risk premium in the market as “the highest it has been in over 50 years., indicating to us that equities are due to rise as the current economic environment is by no means the most challenging it has been in 50 years,” he wrote in his yearend letter which was posted Friday on the internet.
Last year, for example, Paulson made a 43% return  or over $1 billion on Citigroup– buying shares at $3.20 a share and selling them for $4.60 a share later in the year.
The Paulson Gold Fund was up over 35% on the year, as positions in Anglo Gold, Osisko and GLD, the giant gold ETF all paid off bigtime. Paulson is optimistic that gold will outperform for the next 5 years and is “the ideal vehicle to hedge against the risk of the U.S. dollar.”
The funds held $20 billion in 40 different distressed situations where most of the companies have “repaired their capital structures.”
He also sold off positions in major banks like Bank of America, and went long Anadarko, the oil and natural gas producer.
Paulson’s hedge fund has piled up gains of 26 billion since inception in 1994– 3rd biggest killing of all hedge funds. Quantum Endowment Fund, begun by George Soros in 1973,  has racked up $32 billion in net gains. Renaissance Medallion Fund, founded in 1982 by James Simons, has delivered net gains of $28 billion.
He  expects all his funds “to outperform in 2011.”

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IS CHINA DIFFERENT? A FLAWED ECONOMIC MODEL VERSUS TIGER MOTHERS

By Guest Author

“We do not believe in Chinese exceptionalism. China’s economy is no different from any other, in spite of the inevitable Chinese characteristics. If there are such things as economic laws, they work just as well in China and for Chinese businesses as they do in other markets.”
From Red Capitalism, The Fragile Financial Foundation of China’s Extraordinary Rise, p ix
~~~
“What Chinese parents understand is that nothing is fun until you’re good at it. To get good at anything you have to work.”
From “Why Chinese Mothers Are Superior” by Amy Chua, Wall Street Journal, January 8, 2011

In the long run the laws of economics apply everywhere and there is no escaping the dismal science’s somber logic. But our knowledge about economic laws is incomplete. Economics – believe it or not – is really about people and the decisions they make about work and money. What traditional economic models don’t factor in – perhaps because it can’t be quantified and it’s politically incorrect in academic circles to even talk about it – is the character of a people.

From the viewpoint of a free market economist China is following the wrong economic model. Of course anything would be better than the1949-1978 Chinese “model” of continuing chaos and suppression of private enterprise. But today China is following its own version of the mercantilist East Asian model, which involves predominantly state rather than market-directed investment, over-reliance on exports (largely at the expense of the United States), undervalued exchange rates and excess reliance on investment vs. consumption. The model is deeply flawed and unless modified sooner or later will reach a dead-end as Japan has discovered. But “sooner or later” is not a useful concept for investors for whom timing is everything.

As I have previously argued, East Asia is populated by disciplined, hard working, well educated people obsessed with material improvement and conditioned by the obedience/work-oriented Confucian ethic. This type of people can take even a flawed economic model a long way. Read Amy Chua whose Wall Street Journal article about Chinese tough love and “tiger mothers” has caused an international uproar. Chinese mothers program their children to work and achieve. The bottom line for economic forecasters: from an economic perspective all those tiger mothers turn out hard-working model ..........

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