North Korea Attack Impact

Global stock markets have recovered after North Korea launched a barrage against South Korea on Tuesday. Yet military tensions are rising: the U.S. has dispatched warships into the Yellow Sea for exercises with its ally Seoul. What’s ahead for business relations between China, which has close political ties to North Korea, and South Korea?

We exchanged by email yesterday with, Yong-Tack Cho, an editor at Forbes Korea, the licensed Korean-language edition of Forbes magazine. Excerpts follow.

Q. Before this week’s attack on South Korea by the North, economic relations between South Korea and China had been expanding despite China’s close political ties to North Korea. Why have economic and business ties managed to grow despite China’s cozy relationship with the North?

A. Indeed, South Korea and China’s trade relations have developed greatly. Currently, 31% of South Korean exports are shipped to China. This is possible because both countries want to see their trade and political relations as two different things. China has wanted to grow its economy and has needed the investment and technology South Korea can provide. On the other hand, South Korea has wanted entry into the Chinese market and its natural resources. While the two countries do not share the same beliefs about North Korea diplomatically, it would have been unwise trade policy to let that get in the way of trade growth.

Q. What’s ahead for business between China and South Korea, in light of North Korea’s attack?

A. It is unlikely the recent attack will get in the way of trade between South Korea and China, as both governments do not wish for it to get in the way of business. If the situation does not escalate, the impact on economic and trade relations will be meager, as there is no proof or indication that China was involved in the attacks.

Q. What South Korean companies, if any, would be most affected by this week’s developments?

A. We expect that this week’s events will have a large impact on the tourism industry, especially from Japan and China. The Korea Tourism Organization held a meeting with its Japan and China offices on the 24th. While they deny any massive wave of travel cancelations, local travel agencies have been reporting significant losses and falling prices for travel packages to Korea. We expect prices to continue to fall for now.

Q. Before this week’s event, what would you say would likely be the outlook for China-Korean business and economic growth in 2011?

A. Before this week, China was seen as a great economic opportunity for Korea. “How to approach the Chinese economy?” was a question that local companies contemplated 10 years ago. (Since then,) Korean conglomerates such as Samsung, LG, Hyundai Motors, and Posco have regularly increased their investment and built production sites in the region. The two governments are currently formulating an FTA agreement. Even after the attack, we do not believe that it will overly impact our business outlook with China.

Q. What’s the outlook for South Korea’s stock market and currency in light of this week’s attacks?

A. The day after the Yeonpyeong Island attack, the KOSPI dropped 45.02 points (2.33%) in the morning. However, the KOSPI jumped back and closed only 2.96 points (0.15%) lower than the previous day. The Korean stock market has been able to regain its stability despite the attacks because we’ve learn from our past experiences. This isn’t the first time we’ve been attacked by North Korea, and foreign investors have been able to build a certain level of tolerance. As Lee Sung-Woo, an analyst from Daewoo Securities, says: “North Korea’s attack may have influenced the liquidity of the global market momentarily, but they can’t get in the way of a rising nation like South Korea from flourishing in the long haul.”

Devaluing History

Menzie Chinn goes after Paul Ryan’s challenge: “Name me a nation in history that has prospered by devaluing its currency.” But why go back to the 1930s?

How about:

-Britain, which recovered strongly from its early 90s doldrums after it devalued the pound against the mark in 1992. (At the time, some wags suggested putting a statue of George Soros in Trafalgar Square.)

- Sweden, which recovered from its early 90s banking crisis with an export boom, driven by a devalued kronor.

- South Korea, which roared back from the 1997-1998 crisis with an export boom, driven by a depreciated won.

- Argentina, which roared back from its 2002 crisis with an export boom, driven by a depreciated peso.

And more. The truth is that every recovery from financial crisis I know of since World War II was driven by currency depreciation. In fact, that’s the biggest reason for pessimism now: because of the global scope of this crisis, the usual exit is blocked.

Now, I’m sure that the goldbugs will come up with ways to explain away all of these events. But at that point we’re not learning from history; on the face of it, history seems to suggest many cases of countries prospering through devaluation.

So what’s going on with Ryan? First, it’s a good bet that he doesn’t actually know much about monetary history. Beyond that, though, what you often see among hard-money types is a sort of Lives of the Saints approach to history: they’ve got their iconic examples (Weimar Germany! Zimbabwe!) which they pull out on every occasion, while remaining utterly ignorant of all the examples that go the other way.

And no, it’s not symmetric: people like me have heard about hyperinflation, while people like Ryan apparently have never heard about post-crisis Korea or Argentina.

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Top 10 Business Etiquette

1. First and foremost, having good manners is a must. Please and thank you never go out of style. Common courtesy towards others should be second nature.

2. Be on time, or better yet be a little bit early. Be certain that you have allotted enough time for the meeting so you won't be concerned about another place that you have to be.

3. Dress appropriately. If you are uncertain of what to wear, it is always better to err on the conservative side. Business casual is generally the rule of thumb to follow.

4. Prepare yourself ahead of time for both things that you may want to contribute to the meeting, and any information that was given to you ahead of time to read or make notes on. Come prepared to participate in discussions and activities.

5. Upon entering the meeting, glance around the room and acknowledge other attendees. Familiarize yourself with colleagues and managers and make a note of the person who is chairing the meeting. Try to put names to faces if you've met previously and try to remember names of people who have been newly introduced to you.

6. Although it's hard to live without text messages, cell calls and emails, you can do it for the duration of a meeting. It is good etiquette to present the attitude that this meeting is the most important thing on your agenda right now. Leave word ahead of time with the necessary contacts that you will be in a meeting and then switch everything off when you arrive.

7. Don't interrupt the chair when the meeting is in progress. Take notes so you will be prepared to speak up when the time is right.

8. When you do speak out, be clear, concise, and stay on topic. Don't be afraid to present your point of view, but always be respectful of the point of view of others.

9. Information exchanged in a meeting is generally considered confidential among those attending the meeting. Unless you are certain that the subject matter is common knowledge, it is best not to discuss issues with those that were not in attendance.

10. Bring your positive attitude. You'll accomplish a lot more and gain a lot more respect than you will if you are negative and critical.

The Rise Of The Modern Investment Bank

From Clipper Ships to KKR
Adam Smith famously described capitalism as an invisible hand guiding the market in its allocation of goods and services. The financial engines of this hand during the 18th and 19th centuries were European merchant banks, such as Hope & Co., Baring Brothers and Morgan Grenfell. For a time, the Netherlands, and later Great Britain, ruled the waves of global commerce in far-flung ports of call such as India and Hong Kong. The merchant banking model then crossed the Atlantic and served as the inspiration for the financial firms founded by prominent families in what could perhaps be called the emerging market of the day - the United States. The structure and activities of early U.S. firms such as JP Morgan & Co. and Dillon Read and Drexel & Co. reflected those of their European counterparts and included financing new business opportunities through raising and deploying investment capital. (For related reading, see The Evolution Of Banking.)

Over time, two somewhat distinct models arose from this. The old merchant banking model was largely a private affair conducted among the privileged denizens of the clubby world of old European wealth. The merchant bank typically put up sizable amounts of its own (family-owned) capital along with that of other private interests that came into the deals as limited-liability partners. Over the 19th century, a new model came into popular use, particularly in the United States. Firms seeking to raise capital would issue securities to third-party investors, who would then have the ability to trade these securities in the organized securities exchanges of major financial centers such as London and New York. The role of the financial firm was that of underwriter - representing the issuer to the investing public, obtaining interest from investors and facilitating the details of the issuance. Firms engaged in this business became known as investment banks. (To learn more about these functions, read Brokerage Functions: Underwriting And Agency Roles.)

Firms like JP Morgan didn't limit themselves to investment banking, but established themselves in a variety of other financial businesses including lending and deposit taking (i.e. commercial banking). The stock market crash of 1929 and ensuing Great Depression caused the U.S. government to reach the conclusion that financial markets needed to be more closely regulated in order to protect the financial interests of average Americans. This resulted in the separation of investment banking from commercial banking (the Glass-Steagall Act of 1933). The firms on the investment banking side of this separation - such as Morgan Stanley, Goldman Sachs, Lehman Brothers and First Boston - went on to take a prominent role in the underwriting of corporate America during the postwar period; the largest gained fame as the so-called "bulge bracket". (For more on this, read What Was The Glass-Steagall Act?)

The term "merchant bank" came back into vogue in the late 1970s with the nascent private equity business of firms like Kohlberg, Kravis & Roberts (KKR). Merchant banking in its modern context refers to using one's own equity (often accompanied by external debt financing) in a private transaction, as opposed to underwriting a share issue via publicly traded securities on an exchange - the classic function of an investment bank. Many of the large global firms today conduct both merchant banking (private equity) and investment banking.

The Regulatory Infrastructure
In the United States, investment banks operate according to legislation enacted at the time of Glass-Steagall. The Securities Act of 1933 became a blueprint for how investment banks underwrite securities in the public markets. The act established the practices of due diligence, issuing a preliminary and final prospectus, and pricing and syndicating a new issue. The 1934 Securities Exchange Act addressed securities exchanges and broker-dealer organizations. The 1940 Investment Company Act and 1940 Investment Advisors Act established regulations for fiduciaries, such as mutual funds, private money managers and registered investment advisors. In Wall Street parlance, the investment banks represent the "sell side" (as they are mainly in the business of selling securities to investors), while mutual funds, advisors and others make up the "buy side".

Anatomy of an Offering
A company selects an investment bank to be lead manager of a securities offering; responsibilities include leading the due diligence and drafting the prospectus. The lead manager forms a team of third-party specialists, including legal counsel, accounting and tax specialists, financial printers and others.

In addition, the lead manager invites other banks into an underwriting syndicate as co-managers. The lead and co-managers will allot portions of the shares to be offered among themselves. Because their underwriting fees derive from how much of the issue they sell, the competition for lead manager and senior allotment positions is quite intense.

When a company issues publicly traded securities for the first time through an initial public offering (IPO), the lead manager appoints a research analyst to write a research report and begin ongoing coverage of the company. The report will contain an economic analysis of the business and its prospects given the market for its products and services, competition and other factors. Once the analyst initiates coverage, he or she will make ongoing recommendations to the bank's clients to buy, hold or sell shares based on the perceived fair value relative to current share price. (For more on this, read IPO Basics.)

Distribution begins with the book-building process. The underwriting syndicate builds a book of interest during the offering period, usually accompanied by a road show, in which the issuer's senior management and syndicate team members meet with potential investors (mostly institutional investors such as pension funds, endowments and insurance companies). Potential investors receive a red herring, a preliminary prospectus that contains all materially significant information about the issuer but omits the final issuing price and number of shares.

At the end of the road show, the lead manager sets the final offering price based on the prevailing demand. Underwriters seek to have the offering oversubscribed (create more demand than available shares). If they succeed, they will exercise a 15% overallotment option, called a greenshoe, which is named after the Green Shoe Company, the first issuer of such an option. This permits the underwriters to increase the number of new shares issued by up to 15% (from the number stated in the prospectus) without going through any additional registration.

The new issue market is called the primary market. The Securities and Exchange Commission (SEC) registers the securities prior to their primary issuance, then they start trading in the secondary market on the New York Stock Exchange, Nasdaq or other venue where the securities have been accepted for listing and trading. (To learn more about the primary and secondary market, read Markets Demystified.)

Wall Street's Chinese Wall
Investment banking is fraught with potential conflicts of interest. This problem has intensified through the consolidation that has swept through the financial services industry, to the point where a handful of large concerns - the fabled bulge bracket banks - account for a disproportionate share of business on both the buy and sell side.

The potential conflict arising from this is simple to understand. Buy-side agents - investment advisors and money managers - have a fiduciary obligation to act solely in the best interests of their investing clients, without regard for their own economic incentives to recommend one product or strategy versus another. Investment bankers on the sell side seek to maximize the results to their clients, the issuers. When a firm in which the main line of business is sell side, investment banking acquires a buy-side asset manager, and these incentives can be at odds.

Unfortunately for investors, the economics of the business are such that a disproportionate amount of an investment bank's profits derive from its underwriting and trading businesses. The competition for mandates is intense, and the pressure is high on all participants - the bankers, research analysts, traders and salespeople - to deliver results.

One example in particular is research. The research analyst is supposed to reach independent conclusions irrespective of the investment bankers' interests. Regulations mandate that banks enforce a separation between research and banking, popularly referred to as a Chinese Wall. In reality, however, many firms have tied research analysts' compensation to investment banking profitability. Scrutiny following the collapse of the dotcom bubble in 2000 has led to some attempts to reform some of these flawed practices. (To learn more, read The Chinese Wall Protects Investors Against Conflicts Of Interest.)

What About Compensation?
A discussion on investment banking wouldn't be complete without addressing the enormous sums of money that investment bankers are paid. Essentially, a bank's main income-producing assets walk out of the office building every evening. Deals are completed and money is made based solely on the relationships, experience and clever thinking of the professionals who work there.

As such, an investment bank has little to do with the profits it earns except to pay the folks who produced them. It is not unusual for 50% or more of top-line revenues to go into the salaries and bonuses for an investment bank's employees. Most of this goes to the principal architects of the deals, but is also goes to the associates and analysts who toil over discounted cash flow spreadsheets and comparables models until the early hours of every morning.

The catch is that most of this compensation is paid as bonuses. Fixed salaries are by no means modest, but the big seven-figure payoffs come through bonus distributions. The risk for an investment banker is that such payouts can quickly vanish if market conditions turn down or the firm has a bad year. (For more on the life of an investment banker, read Is Investment Banking For You?)

Investment bankers spend an inordinate amount of time trying to figure out new ways to make money - in good times and bad. Business areas like M&A, restructuring, private equity and structured finance, most of which were not part of an investment bank's repertoire prior to the mid to late 1970s, provide evidence of this profession's ability to continually find new ways to make money.

The Bottom Line
For all the mystery surrounding investment banks, the role they have played throughout the evolution of modern capitalism is fairly straightforward. These institutions provide the financial means to enable Adam Smith's invisible hand to function.

Investment banks have flourished in a variety of economies, from the merchant traders of 18th-century London and Amsterdam to the behemoths of today, whose influence spans the globe. As long as there is a market economy, there are likely to be investment bankers coming up with new ways to make money, while the rest of us marvel at how they manage to do it.

Madoff Trustee Sues UBS For $2 billion

Irving Picard, the court-appointed trustee for Bernard Madoff’s bogus investment firm, has gone after a big bank in his expensive two-year quest to retrieve funds for some Madoff investors.

Picard filed a complaint against UBS in Manhattan’s federal bankruptcy court yesterday, accusing the Swiss bank of fraud and misconduct in connection with feeder funds that funneled investor cash into the Ponzi scheme. The lawsuit seeks to recover at least $2 billion.

In a press release, Picard claims UBS actively assisted the Madoff Ponzi scheme by sponsoring and administrating Luxalpha SICAV and Groupement Financier, two feeder funds. Picard says that UBS’s own due diligence revealed “indicia of fraud” with the UBS feeder funds, but that UBS nevertheless made Bernard Madoff the subcustodian of the feeder fund assets, allowing Madoff to “run the operation with no checks and balances.” Picard says that UBS enabled Madoff to be the “only source of information for valuing the funds.”

In the complaint, Picard claims the UBS-sponsored feeder funds withdrew $1.12 billion in the six years before the the Ponzi scheme collapsed and resulted in a bankrtupcy filing, making those funds potentially recoverable under federal bankruptcy and state law. Picard claims UBS and its affiliates made some $80 million in fees from the feeder funds.

“Madoff’s scheme could not have been accomplished unless UBS had agreed not only to look the other way, but also to pretend that they were truly ensuring the existence of assets and trades when in fact they were not and never did,” David Sheehan, Picard’s lawyer, said in a statement.

Sheehan said that Picard has “battled” with UBS over disclosure of information regarding Bernard Madoff Investment Securities.

The lawsuit is the latest effort in Picard’s controversial effort, which has included attempts to clawback funds from some of Madoff’s victims. So far Picard has recovered some $1.5 billion, but the vast majority of that sum was simply recovered by grabbing the cash that remained on hand in Madoff’s investment company following the exposure of the fraud. It has been a rich business for Picard and his firm, Baker Hostetler, yielding more than $85 million in fees.

But Picard and Sheehan claim they are on the right track. Said Sheehan: “Without UBS’s serving as promoter, custodian, manager and administrator for the feeder funds, [Madoff] would have been deprived of more than a billion dollars in investments, and Madoff’s fraud would have been diminished.”

George Soros Raises InterOil (IOC) Stake

Soros Fund Management just filed an amended 13G with the SEC regarding their position in InterOil (IOC). Per activity on October 25th, George Soros' hedge fund now shows an 11.9% ownership stake in IOC with 5,257,422 shares. This comes after we just disclosed that Soros boosted stakes in two other positions.

Of this total, 1,200,000 shares are represented by call options. Since the second quarter ended, Soros has increased their position size by 53.5%. Interestingly enough, InterOil just yesterday afternoon announced that they would offer convertible senior notes due 2015 and common shares to raise proceeds of up to $280 million.

InterOil has been somewhat of a controversial stock in the hedge fund world. While Soros has amassed a hefty long position, Whitney Tilson's hedge fund T2 Partners has been an ardent detractor of the company as they are short IOC. Soros has clearly been the winner on this play thus far and we'll have to see what happens in the future.

Taken from Google Finance, InterOil is "an integrated energy company operating in Papua New Guinea and its surrounding Southwest Pacific region. The Company operates in four business segments: upstream, midstream, downstream and corporate."

Thank the Pilgrims for eBay

The story of the Pilgrims' first years in America shows how a change from common ownership to private property led to the feasting celebrated today at Thanksgiving. Similar tales of expanding harvests and benevolence are told wherever people can keep the fruits of their labor and trade them as they please.

The story illuminates why eBay and Chicago Mercantile Exchange Holdings, the owner of the Chicago Mercantile Exchange, were among the two best-performing stocks in their class during each of the last two years, and it provides a useful signal that other markets now preparing to go public might be good investments.

After landing at Plymouth in November 1620, the Pilgrims endured a cold, hungry winter during which half of them died. Promised supplies failed to arrive from London. The 1621 harvest wasn't as big as hoped, nor was the 1622 harvest. More famine seemed inevitable.

And then the colony began to talk through the problem. The London merchants who financed the Pilgrims' settlement specified "that all such persons as are of this colony are to have their meat, drink, apparel, and all provisions out of the common stock and goods of the said colony." In 1621, the Pilgrims planted 26 acres, according to Judd W. Patton, an economics professor at Bellevue University in Nebraska. In 1622, they planted 60 acres, but that wasn't enough to keep hunger away.

People began to steal by night and day, "although many were well whipped," Gov. William Bradford reported.

The system made no sense to anyone. The hard-working subsidized the slackers. The young and ambitious didn't want to do work for anyone else and get nothing for their trouble. The wives of some of the men objected to be commanded to wash clothes, dress meat or do other tasks for other men.

As Bradford would later write in "Of Plymouth Plantation 1620-1647," "At length, after much debate of things, the Governor (with the advice of the chiefest amongst them) gave way that they should set corn every man for his own particular, and in that regard trust to themselves, in all other things to go on in the general way as before."

In what's known today as the Land Division of 1623, each family was allotted land at the rate of one acre per family member and told to go out and produce. More than 184 acres were planted that year. And, Bradford reported, "This had very good success, for it made all hands very industrious, so as much more corn was planted than otherwise would have been by any means the Governor or any other could use, and saved him a great deal of trouble, and gave far better content. The women now went willingly into the field, and took their little ones with them to set corn."

What is apparent from this history is what we all know from our experience: When you can benefit from working hard, you work harder. Under the system of common ownership, there was stealing, shirking and malevolence. Under the incentive system, there was good feeling, hard work and benevolence.

News of the success at Plymouth and other settlements like it attracted more and more immigrants to the New World. And everyone who lives in America today has a personal story that is part of that great continuing tale.

The impulse to improve one's conditions through greater effort and trade is as natural as breathing, and this has been so since the beginning. New York University economist Haim Ofek, in "Second Nature: Economics Origins of Human Evolution, argues that trade helped spur the growth of the brain.

"Exchange requires certain levels of dexterity in communication, quantification, abstraction, and orientation in time and space, all of which depend on the lingual, mathematical and even artistic faculties of the human mind," Ofek writes in the introduction to his 2001 book. "Exchange, therefore, is a pervasive human predisposition with obvious evolutionary implications."

Relatively flexible and acute people had an edge in trading. They survived and prospered, they had bigger, healthier families, and their descendants became dominant.

The success of eBay since its founding in 1995 shares many similarities with the Pilgrim story. Now a public company with a market value of around $75 billion, eBay has created an electronic network of niche markets that takes account of the infinity of human tastes and aptitudes and specializations. The stock is up 72-fold since its September 1998 IPO, from a price-adjusted initial price of $1.50 to $109.42 as of Nov. 15. That is after a 77% drop in the tech crash of 2000.

Like the Pilgrims, eBay gives each of its sellers a piece of land (though in virtual space) to carry out his or her business. A spirit of benevolence is apparent in the company's feedback system; in almost half the transactions, both buyer and seller rate each other, with almost all them highly favorable. But to us, there is one overriding reason for eBay's success: It unleashes the desire and provides a forum for buyers and sellers to improve themselves by trade in a million ways every day.

The CME, odd as it sounds, also bears some similarities to Plymouth Colony. Founded in 1897 as a member-owned organization, the Merc started out as a market for the trading of foodstuffs. Its activities and goals were torn between the interests of the members and the interests of the public. A low point was reached in 1989, when a widely publicized sting operation uncovered conflicts of interest and failures to give the public a fair shake.

For years, the Merc had been content to play a sleepy second fiddle to the Chicago Board of Trade both in volume and number of products traded. In 1972, an inspirational governor — in this case, Leo Melamed — decided it was in everyone's interest to match members' interests with the growing public interest in financial products such as currencies, Treasury bills, Eurodollars and stock market futures. Growth exploded in 2000 as the CME prepared for the shift to public ownership by converting members' interests to shares. Since the Merc went public in December 2002 with its shares listed on the New York Stock Exchange, the stock has risen nearly six-fold, and it has stayed in the top 10 of NYSE performers.

In effect, the CME transformed itself from a tradition-bound club with the image of a raucous den where men shouted at each other to get an edge on the public in trading pork bellies. Instead, it became a pioneering company that lets hardly a week go by without introducing a new electronic product designed to give the public more ability to improve and hedge their ownership of stocks and debt.

The table below shows how acreage planted and revenues grew at Plymouth, the CME and eBay.The Plymouth, Chicago Merc and eBay experiences
Year Plymouth acres planted CME revenue* eBay revenue*
(1621/2000) 26 $226.6 $431.4
(1622/2001) 60 $387.2 $749.8
(1623/2002) 184 $453.2 $1,214.1
(2003) $526.1 $2,165
(2004)** $743.8 $3,260
* In millions **Analysts' estimates


The Pilgrims originally agreed with the London merchants who financed their settlement to hold their land and its products in common, a sort of forced socialism, much as the communists imposed on Russia after the 1917 revolution.

And the Pilgrims learned, as the Russians would, that the system led to misery and poverty. Whenever trade and its rewards are permitted, well-being and output improve across the board. The principle is so mundane that it's hard to believe that it could ever be forgotten. But it was. The Soviet economy broke down because people had no incentive to reduce costs, to produce a quality product, to provide the kind of gracious service that an American expects from even a humdrum retailer.

If it weren't for those who risked death — literally — to start private enterprises on the black market, the Soviet system would have collapsed long before it finally did.

Everyone knows a million examples of how people respond to incentives. It's no accident that when President Bush won a reduction in taxes on capital gains and stock dividends in May 2003, the S&P 500 ($INX) responded with a 27% rise. Incentives to buy stock increased, so prices rose. The after-tax returns from stocks increased, so the public decided to place more dollars into stocks versus the alternatives.

In Plymouth, thanks to the gift of the Land Division of 1623, trade was created, and it did what it has always done:
It allowed economic freedom. The Pilgrims borrowed the money to start their colony. Their decision to redistribute the land allowed rapid repayment and the freedom to practice their beliefs as they wished.
It financed new enterprises. The Virginia Company of Plymouth served its own interests by lending to farmers, giving the company a chance to increase its agricultural imports.
It increased output. When each Pilgrim family gained the freedom to labor as they wished in exchange for the freedom to keep their crop, yields increased.

We believe the successes of the Pilgrims, the CME and eBay are not anomalies. And we will predict success for any company or country that lets people trade as they are predisposed to do by instinct and common sense. If the International Securities Exchange and Chicago Board of Trade follow through on plans to offer shares to the public and if the New York Stock Exchange ever goes public, we'd recommend buying those stocks.

Five Megathemes That Will Dominate Indian Economics Over The Next Five Years

Lately it seems that the entire world has forgotten that in addition to China, the EMs are also the BRI - Brazil, Russia and India. However, now that Brazil is outright hostile toward US policies (not so much toward China), and Russia continues to be Crazy Ivan, the only relevant other overheating economy appears to be India. The reason why India has not attained much media attention in recent years, is that unlike China, the country has been doing its thing and not engaging in overt or covert conflict with the developed world. And as China's inflationary star may be waning, we believe ever more investors will continue looking toward India. Which is why, courtesy of Ambit, we present an analysis of what the investment bank believes will be the five key megathemes which will dominate the Indian economy over the next five years.

Megatheme 1: Structurally high inflation

Supply constraints in India’s manufacturing sector have historically caused core inflation to spike every time the economy expands rapidly (see Exhibit A on the left). Limited access to finance, hard infrastructure deficits and labour market issues have and will prevent timely supply responses in this demand powerhouse thus driving manufacturing inflation higher. Furthermore, a growing and young population with rising incomes will cause food demand to grow rapidly, while supply responses continue to be weak. This supply-demand mismatch will drive food prices higher over the next decade.

High inflation has historically been a negative for stock market returns (see Exhibit B on the left) as it crunches companies’ margins through higher input costs. Financial services’ companies emerge as being the most inflation-immune due to their limited exposure to employee costs as well as to raw material costs. Commodity-driven sectors emerge as an obvious hedge against higher commodities’ prices. IT and other labour-intensive export-facing sectors appear to be the most vulnerable to high inflation as higher domestic wages erode their price competitiveness.

Megatheme 2: the rise of the “aspirational” consumer

As a country’s per capita incomes rise, the consumption basket of its citizens changes away from food (see Exhibit C on the left) and essentials to non-food and aspirational items (such as cosmetics, motorbikes and jewellery). India’s consumption basket has been undergoing just this sort of change. Given the structural drivers of this trend (rising incomes, high share of youth and urbanisation), investors should focus on aspirational product manufacturers vis-à-vis essentials within India’s broader consumption story. Exhibit 25 on pg19 gives a list of aspirational stocks. Exhibit 23 & 24 on pg 19 show the outperformance of aspirational stock vis-à-vis consumer essentials.

Megatheme 3: a capex boom in the making

The experience of India’s Asian neighbours suggests that a high GDP growth rate coupled with the investment:GDP ratio hitting 33% triggers a surge in capex (see Exhibit D below). These trigger points along with India’s infrastructure deficit and the Government’s desire to address this deficit has set the scene for a seven year surge in capex. History suggests that the Indian Capital Goods sector stands to gain most, both from profitability and from a stock price perspective, from this impending surge in capex.

Megatheme 4: The coming of age of financial intermediation

India’s per capita income in PPP terms recently breached the $ 3K and its savings to GDP ratio stands at a healthy 32%. Cross country experience suggests that India’s savings ratio should touch ~40% in FY15(see Exhibit E on the left) and will continue to rise until India’s per capita income reaches $ 8 K (in PPP terms) and will max out only at 46%. The disproportionate rise in the quantum of India’s savings over the next decade heralds tremendous opportunities for financial intermediaries as the Indian saver looks to channelize these savings into not just bank accounts but into stocks and bonds as well.

Megatheme 5: India will become a hotbed of conflicts

Whilst the ongoing and widespread conflict in central India between the Indian establishment and Maoists generates headlines, we see a broader theme in these stray instances of conflict and expect their intensity to trend upwards over the next decade as inequalities persist.

As corroborated by cross country experience, the unequal distribution of gains of economic development across social groups and individuals will be the main driver of this trend (see Exhibit F on the left). A vast and stratified populace with a youth bulge will add to the conflict risk.

The escalation of the Maoist movement, indisputably the biggest threat to internal security will pose challenges for the Metal and Mining Sector (refer to Exhibit 59 on pg 36 for details of company-level exposure to Maoism). Security costs for the corporate sector as a whole will rise as crime rates and the frequency of conflict trends upwards. Indirect costs in terms of political donations, bribes and CSR initiatives will be the other head under which costs will rise. Additionally, the corporate sector will continue to partially fund the Government’s fiscal transfers directed at rural India. FMCG and aspirational product companies stand to gain from these transfer payments.

The Pot Again Calls The Kettle Red Republicans Democrats The Fed and QE2

Some conservatives are attacking current U.S. monetary policy as being too expansionary, as likely to lead to excessive inflation and debauchment of the currency. The Weekly Standard is promoting a letter to Fed Chairman Ben Bernanke that urges a reversal of its policy of QE2, its new round of monetary easing. The letter is signed by a list of conservatives, most of whom are well-known Republican economists, some associated with political candidates. Apparently the driving force is David Malpass, who was an official in the Reagan Treasury, and he is taking out newspaper ads later this week. This follows similar attacks on the Fed by politicians Sarah Palin, Mike Pence, and Paul Ryan.

If the National Journal, Wall Street Journal and Politico are right that the Republicans are trying to stake out a position that Democrats are pursuing inflationary monetary policy, they are on shaky ground. I will leave it to others to make the important point of substance: the risk of excessive inflation is low now compared to the risk of an alarming Japan-style deflation, with the economy having only begun to recover from its nadir of early 2009. Or to acknowledge that Quantitative Easing is only a second best policy response to high unemployment. (Fiscal policy would be much more likely to succeed at this task, if it were not for the constraints in Congress.)

I will, rather, respond to the political component of the National Journal’s question by pointing out some insufficiently understood history:

1.Republican President Nixon successfully pushed Fed Chairman Arthur Burns into an excessively easy monetary policy in the early 1970s — leading to high inflation which the White House tried to address with wage-price controls. Nixon, of course, also devalued the dollar, and took it off gold, thereby ending the Bretton Woods system.
2.Republican Presidents Ronald Reagan and George H.W. Bush tried aggressively to push Fed Chairmen Paul Volcker and Alan Greenspan into easier monetary policy, especially in election years. This is documented in Bob Woodward’s 2000 book Maestro. The White House succeeded in making life unpleasant enough for inflation-slayer Volcker that he eventually declined to be reappointed, prompting James Baker to exult “We got the son of a bitch!” (p.24).
3.Democratic Presidents Jimmy Carter and Bill Clinton are the two presidents in the last four decades who have refrained from pushing their Fed Chairmen (Volcker and Greenspan, respectively) into inflationary monetary policy.
4.Under Republican President G.W.Bush, monetary policy once again became excessively easy, during 2003-06, contributing substantially to the housing bubble and subsequent crash.
Thus if the other party were to accuse Democrats of pursuing excessively inflationary monetary policy, it would be akin to them accusing Democrats of pursuing excessively expansionary fiscal policy. Perhaps such accusations will strike some who don’t pay close attention as superficially plausible, even after all these years. But they nonetheless fly in the face of history. Another case of the pot calling the kettle “red.” Yes, I know, the usual saying is about the color black. But red is the color of deficits, overheating, … and Republicans.

Lessons I learned in my trading days

Having read Liz'a article, made me think about lessons I learned in my trading days.

1. Hedge fund is all about risk control, which includes counter trend protection and margin management, without that, you will see yourself in square one some time in next twenty years.

2. Never, ever read commentators, just remember, they don't have to make a living by writing market comments if they know how to invest/trade.

3. Do follow Pundits, do subscribe Barron's, if you have money, subscribe value line, that two will keep you occupied for your reading time. Take the most bullish call from prime bearish pundits, and take the most bearish call from prime bullish pundits. You won't make much mistake following that.

4. Discipline, discipline, discipline.

5. After a dear friend of mine calls me "worry bug", I realized the true reason I quit trading: No Guts and worry too much!

The Biggest Lesson I Learned from Running a Hedge Fund

In the late 90s, I ran a hedge fund.

Correction—I was the CEO for the hedge fund, responsible for marketing the fund and growing the business. I was not the portfolio manager and I had no responsibility for buying and selling the investments.

Despite that fact, and despite the fact that our fund followed a long term “buy and hold” strategy where we committed to selling less than a quarter of the investments each year and aspired to keep portfolio turnover below 10%, I had CNBC on constantly—watching the latest market news, obsessed with how stock price changes impacted the value of our portfolio.

I look back now and wish I could get those hours back. I wonder how much more effective I would have been if I shut the TV off and redirected my attention to things that really mattered, where I had some degree of control over the outcome.

Would I have been a better, wiser, more balanced leader if I calmly accepted that the value of our portfolio would change constantly—sometimes randomly—based on rumors, large trades, and missed “whisper numbers” (what the “street” thinks the earnings will be despite the fact that the management team estimated lower—a strange game of poker where you think you know the cards better than the person holding them)? I think so.

One of our investors said it best when I asked why he never called me when the market was down as most of our other investors did. “What does the value of the Dow on Tuesday at 10:58 AM have to do with my long-term financial goals? Absolutely nothing.”

Here’s what I (eventually) learned:

The daily stock market news is just noise. Distracting, disconcerting, and to the extent you act on this information rashly, it can be deadly from a financial perspective. (Fortunately I didn’t have trading authority so this didn’t happen with our fund, but it happens every moment of every day to individual investors.)

Investing in stocks is investing in a business. What CEO or business owner calculates the book value of the company on a daily basis? It would be a complete waste of time. The CEO or business owner focuses their time on building the business, studying the industry and the competition. So why would investors care about the daily price? It is very misleading. The daily stock market news cycle is partly to blame for the short-term focus.

Even respected business journalist Maria Bartiromo, who gained fame by reporting on the floor of the New York Stock Exchange, states that investing for the long term is the best way to create wealth, and that watching reports such as the ones she gave for years makes little difference. Gary Belsky, former financial journalist and author of Why Smart People Make Big Money Mistakes and How to Correct Them, told us that he left financial reporting to become an editor at ESPN because once he understood behavioral finance he no longer felt right about reporting on the daily or even monthly goings-on in the market.

Here are three ideas on where to redirect your attention:

Watch the news, not the market.
Keeping up on general economic trends as well as industry news on the investments you own is a much better place to spend your time than watching the 24-hour news cycle. As an investor, I have always been interested in how business leaders think. To me, learning about their leadership style and focusing on where they can grow the business is what is important. The information gathered from watching industry and company specific news is much more valuable in making investment decisions than watching an endless stream of ticker symbols.

Don’t follow the herd.
The average investor gets in at the wrong time and, of course, follows that with selling at the wrong time. In fact, there used to be a popular indicator of when to buy and sell called the “odd lot” theory. The premise was that small investors who normally trade in small amounts of less than 100 shares often made poor investment decisions. Today, small investors generally trade in mutual funds, but this theory is very telling as you’ll see in the next point. Remember the herd is watching the same cable TV program you are.

Buy and hold – don’t time the market.
According to a Dalbar study, access to market information may actually hurt the returns of the individual investor. You would think with more information investors would have better returns and beat the market, but that was not the case. According to the study, which covered the 20-year period from 1988-2007, the S&P 500 had annualized returns of 11.81%, while investment-grade bonds returned 7.56%. The average equity fund investor had returns of only 4.48% — worse than Treasury bills which returned 4.49% annually for the same time period. The reason: Most individual investors are overly sensitive to market swings and end up buying high (feeling they need to get in the game after seeing the market rise significantly) and selling low (out of fear that the market is going to plummet further).

Investors would be better off ignoring the day-to-day market changes and studying the words of great investors like Warren Buffett, David Dreman, and Benjamin Graham. Instead of news anchors reporting the daily market quotes, I’d like to see them reporting successful financial strategies. With the poor state of financial literacy in this country, what we need is less “noise” and more helpful information that people can actually use.

Marc Faber: The Developing World Should Be Thanking Bernanke, Not Yelling At Him

Notes: I received many emails asking why I like Marc Faber so much. as he is so dark, so bearish, so crazy. I agree he is but he is also extremely talented. As a prime bear, the first thing Marc says is always the same: I am ultra bearish on everything. It is the same as we say: in the end, we all die. To read Marc, you should skip all bearish comments and only pick his action calls, which 90% are mid term correct. He has been calling for bond to dip for a while and I do agree it's going down hill.

Marc Faber spoke to CNBC this morning about U.S. monetary policy decisions and the threat of an emerging markets bubble. He was joined by Frank Berlarge of Multilateral Partners Global Advisory Group.

0:30 Faber: The cause of the crisis is excessive monetary growth leading to excessive debt growth to the NASDAQ bubble to the housing bubble to over consumption in the U.S. A symptom of overconsumption is a trade deficit, which then exports production overseas.
1:20 Faber: The developing world should send a thank-you note to Mr. Bernanke.
Frank Berlarge of Multilateral Partners Global Advisory Group talks about the importance of foreign inflows to the U.S….
3:35 Faber:A dream to think the U.S. can double its exports in the manufacturing sector, but the U.S. can export more in the agricultural sector.
Berlarge then argues that the U.S. can grow its exports; doesn't see a doubling without tax policy.
5:15 Faber: Criticism from emerging economies towards the Fed is all about worries over bubbles forming "too much of a good thing." When those currencies deflate, people jump in, and asset prices surge. The excess liquidity is running into emerging economies and precious metals.
Berlarge talks about how we're not going to be get out of this mess without inflation, and Bernanke is acting as a janitor, cleaning up the mess. The threat is to the banking industry, and that's why he's trying to prop up housing markets.

Long Term Stock Market Cycle: Where Are We Now?

This morning, Market Folly's quote of week focused on wisdom from value investor Joel Greenblatt. A few sentences in particular stuck out where Greenblatt says:

"Over the long term, despite significant drops from time to time, stocks (especially an intelligently selected stock portfolio) will be one of your best investment options. The trick is to GET to the long term. Think in terms of 5 years, 10 years and longer."

Given his commentary, the chart below is a perfect illustration of "the long term." This chart, courtesy of DecisionPoint (via Cynical Advisor) depicts how the stock market has traded in 16-18 year bull/bear cycles ever since 1932.



Currently, the market appears to be in the bear cycle where it essentially chops sideways via wild oscillations every few years. By the chart's calculations, this means the market will be stuck in its current cycle for another 5-7 years before entering another bull cycle. This of course assumes the current trend of alternating cycles remains in tact. Focusing on the drawn-in trendline, a break below the level of 500 on the S&P would obviously be quite a negative signal jeopardizing the multi-decade trend.

In the end, this chart simply illustrates Greenblatt's notion of "long term." In a day and age when everyone is so focused on short-term performance, hopefully this forces you to take a step back and examine things from a multi-decade perspective. While the current trend is choppy to say the least, the long term trend is most definitely up. The problem for most investors though is the lack of ability to remain on course. Whether it be poor market timing or succumbing to emotion, investors have time and time again found a way to deviate offtrack.

Interview With The Mad Hedge Fund Trader

Here's a recent interview Ilene from Phil's Stock World recently did with the Mad Hedge Fund Trader. Enjoy:

Mad Hedge Fund Trader began his career in finance by moving to Japan and working at Dai Nana Securities as a research analyst in 1974. In 1976 he was named the Tokyo correspondent for The Economist magazine and the Financial Times, which then shared an office. He traveled the world interviewing famous people, such as Ronald Reagan and Margaret Thatcher. In 1982, he was named the US editor of Euromoney magazine, and in 1983 he built a new division in international equities for Morgan Stanley. After moving to London in 1985, Mad Hedge supervised sales and trading in Japanese equity derivatives. In 1989, he became a director of the Swiss Bank Corp, responsible for Japanese equity derivatives. A year later, he set up an international hedge fund which he sold in 1999.

I haven’t even covered all of Mad Hedge’s adventures, such as his latent movie star career (as an extra in the 1979 epic war film, Apocalypse Now), and who knows what else. But now, missing the adrenaline-surging excitement of active trading, Mad Hedge has returned to the hedge fund business, set up an educational website, and is busy keeping up with the demands of newsletter writing.. So let’s begin our interview with Mad Hedge by exploring his current thoughts on the markets.

Interview

Ilene: Hi Mad Hedge. You’ve had a fascinating career having little to do with your major in biochemistry. A brief review of your newsletter shows that your recommendations early in 2009 have appreciated by an average of around 400%. You’ve been writing your daily market thoughts and investment strategies at your website - www.madhedgefundtrader.com - which it’s terrific, by the way. What are your goals with this site?

Mad Hedge: This whole thing started out as a letter to investors in my hedge fund, to tell them my thinking behind my positions. Then I thought, why not post this on the web and see what happens? Six months later it is now going out to 50,000 readers a day, mostly to portfolio managers, financial advisors, and traders. The growth has been explosive.

Ilene: Who are your readers?

I seemed to have stumbled on a market that I describe as “semi-professionals.” If you are a big hedge fund, with a staff of 600 and a huge in-house research department, I’m not going to tell you anything you don’t already know. But there appear to be a few million people out there who trade their own accounts, or invest their own IRA’s. They have never worked on Wall Street, but have taught themselves a lot about markets and investing. My letter gives them the 30,000 foot view on global stock, bond, currency, commodity, and real estate markets which they can’t find at their online broker. About half of them are from abroad. When I get up in the morning now, there are five e-mails waiting for me from China and India asking what to do about natural gas. I also try to make the letter funny and entertaining. Not all financial publications have to be dreary reading. It’s not always about the next stock to buy.

Ilene: In a recent letter you wrote that one of your favorite ETF’s is the Proshares Ultra Short Treasury Trust (TBT). Why is that?

Mad Hedge: TBT is a 200% leveraged bet that long Treasury bonds will go down. While the Fed keeps short rates low, it doesn’t directly control long rates. As the supply of government bonds increases exponentially, their eventual collapse is inevitable. All Ponzi schemes must come to an end, and the US government is no exception. We currently have the greatest liquidity driven market of all time, and the ten year is eking out a mere 3.30% yield, pricing in near zero inflationary expectations. The average yield on this paper for the last ten years is 6.20%. If the yield goes back to 5%, that will take the TBT from $45 to $70. The TBT could perform even better if Treasuries lose their triple “A” rating, which I think is a real possibility.

Historically, bonds are not a good buy in a low interest rate, deflationary environment. If long rates move from 3% back to the 12% we saw in the early eighties, bond holders will get slaughtered, and the TBT could exceed $200. Even if inflation stays low, the sheer weight of supply and credit concerns will crater government bond prices.

Ilene: What’s the worst case scenario for the bond market?

Mad Hedge: Debt service is currently 11% of the budget. If interest rates rise sharply, that could double to 22%. Then you get a downward spiral like you saw in Latin America in the eighties, when higher debt service creates more borrowing, and more borrowing creates a higher debt service, until the whole thing blows up. At some point China, Japan, the Middle Eastern countries may stop buying our debt. There are only so many “greater fools” out there.

The only way out of this is for the economy to return to a long term 3%-4% growth rate. That’s obviously what Obama is hoping for with his programs. He’s taking big risks, but he doesn’t have much choice. He really did inherit a bad hand. If he did nothing, we’d be in a depression by now, with 25% unemployment. He understands what he’s doing and understands the risks. He has great economic advisors.

Obama couldn’t have allowed the banking system to collapse. We need banks as the economy’s lynchpin. A year ago we could have lost the entire financial system over a weekend. Ships were being turned around at sea and going back home because their letters of credit were failing. The freeze up in credit could have gone on for years.

The stock market is up 50% since Obama took office, so it likes the uneasy stability that we have now. Credit markets have recovered tremendously, and IPOs are coming to the market again. Junk bond funds are up, confidence is returning. There’s greater willingness to lend, though only at high interest rates. But it’s a big improvement over last year.

Ilene: What do you expect for mortgage rates in the next few months? Years?

Mad Hedge: You shouldn’t touch real estate, as I think it will be dead money for another decade. Rent, don’t buy. If you have to buy, then get a 30 year fixed rate mortgage now at 5%, because rates are going up a lot in the future. When I bought my first home in New York in the early eighties, I got nailed with a 17% interest rate on my mortgage. We may revisit those levels.

Houses will continue to move lower, maybe another 10% or so. We have another wave of foreclosures hitting the system soon, triggered by the option arm readjustments. I see support for prices when the cost of owning and the cost of renting are more in line. Home ownership may have to become cheaper than renting, because of perceived risk to the principle, for the real estate market sell-off to finish. However, expecting houses to drop a lot from here is like shorting Citibank at $3. We’ve basically had the big move already. Due to poor demographic factors, the demand for houses is going to take a long time to come back. While 80 million baby boomers are trying to sell their houses to 65 million gen Xer’s, don’t expect a recovery in prices, especially when the gen Xer’s are still living in your basement.

Ilene: You mentioned you missed the rally in financials, but still have concerns about the financial sector.

Mad Hedge: With financials, I knew they would rebound, but didn’t imagine the extensive move we’ve seen. It was the greatest dead cat bounce and short covering rally of all time. But the financial sector will have troubles for years. If I had to buy U.S. stocks, I’d buy big tech stocks like Microsoft (MSFT), Oracle (ORCL), Intel, (INTC) and Cisco (CSCO), because for the most part they have tons of cash and little debt. Tech stocks didn’t have the problems that were plaguing the other sectors. For example, they have no troubled assets, and no regulatory clamp down on their business. The credit crisis didn’t affect them directly because they finance their operations through cash flow and tend not to borrow. Of course, they’re hurt indirectly when the customers have credit problems.

Credit markets are now seeing a huge differentiation in terms. Lenders are much more discriminating about who they lend to. American consumers are very constrained, but foreign consumers are not as constrained. They are not returning to frugality as we are because they didn’t share our excesses in the first place. You don’t see many black Cadillac Escalades with chrome wheels in China. If I had to buy stocks, I would buy equity in foreign companies where the growth will be in the coming years. In March, you could have bought anything and had a great trade, as the rising tide lifted all boats. But stocks in emerging markets outperformed US stocks by over a two to one margin.

Ilene: Would you be buying stocks now?

Mad Hedge: No, I sold most of my positions in June. The risk was low in March, but not so low in June, and it’s even greater now. The PE multiple on the S&P 500 has just jumped from 10 to 20 in six months. Historically, a 20 multiple is a terrible time to enter the market. Markets are discounting a “V”-shaped recovery, which we are not going to get. I think we’ll get more of a “square root” shaped recovery, a “V” followed by sideways to a gradually upward sloping grind. We’ve already had the “V”. Markets are overpriced. I don’t see how we can have huge economic growth with capital-constrained banks, catatonic consumers, and commercial real estate troubles up the wazoo. One of the only positives is the weak dollar, which makes everything we sell to the rest of the world cheaper. This is good for our multi-national companies, good for our exporters. So far, the dollar is on a grinding, controlled move down, which is good. But if the dollar’s fall accelerates, it would not be good. A real dollar panic would lead to the widespread dumping of dollar assets, and commodity prices would explode. Then we’ll get to $2,000 for gold and $40 for silver very quickly.

Ilene: You spent several years wildcatting for natural gas in Texas and Colorado, which has given you a unique insight into the energy space. What are your current thoughts on natural gas and oil?

Mad Hedge: Stay away from natural gas. The volatility will kill you. If you are a masochist, then buy it only when it’s cheap, on big dips, in the $3/MBTU range. In the last three years, thanks to the new “fracting” technology used in oil shales, we have discovered a 100 year supply of natural gas sitting under the US, and the producers have not been able to cut back fast enough. So now we have a supply glut, and we are almost out of storage. This is what took us down from $13 to $2.40 in 18 months. The lack of hurricanes has not helped demand either. Producers have been cutting back like crazy, trying to balance supply and demand, with a breakeven point of $2. They need a cold winter to help bring things back into balance. If the industry gets organized, then gas can become the 20 year bridge we need, until energy alternatives kick in. That makes me a big supporter of the “Pickens Plan.”

Oil is much more interesting. It overshot to downside in January to $32. Crude is now at $70 climbing out of the recession. Imagine how high it will get when all economies are functioning again. The financial crisis hurt the ability of big oil companies to get financing for large development projects in oil. These projects can take five to ten years to bring online. That means we will get higher oil prices sooner. We may get a pull back to the $50s, but the $30’s would be a stretch. The $32 low was an artificial one caused by a complete absence of liquidity in all markets. I don’t think we’ll see those lows again.

Ilene: Where do you see the price of oil going in the distant future?

Mad Hedge: I think it may dip into the 50s, then up, perhaps skyrocketing to $300 before dropping back down to $3 after alternatives take over and demand vanishes. But that’s at best 20 years out. If we can wean ourselves off oil in 20 years, it would be a huge accomplishment.

Ilene: I noticed you speak a little about politics in your essays; do you have a leaning one way or another?

Mad Hedge: I’m politically neutral. I’m getting bashed by the right these days because I’ve said that the Republicans have no ability to affect the legislative process now. But we need to adjust our portfolios to reflect the current political realities. No matter how much you love Obama, you can’t dispute the fact that the massive issuance of government bonds he is proposing is terrible for the bond market and the dollar, but great for precious metals and commodities. Obama won by a big margin, so the Democrats will be around for a while. Of course, if my “square root” scenario doesn’t pan out, and we get a serious “W” recession instead, all bets are off. People will only give him the benefit of the doubt for so long.

Ilene: Where do you think the stock market’s going to go over the next few years?

Mad Hedge: I think there’s a 1 in 3 chance for new lows. That’s the “W” scenario. But with Lehman, Bear Stearns, Merrill Lynch, and Washington Mutual gone, we have run out of companies that can suddenly go under and trigger a new financial crisis. The big survivors are partially government owned, and of course zero interest rates help a lot. More banks are going under, but they will be smaller, regional banks with excessive exposure to commercial real estate.

Ilene: How does this affect your actions in the markets?

Mad Hedge: The best and least risky trades were in the early part of the year. Now, there’s a lot more risk in all markets. I’m neutral right now. If stocks dropped from here, I might be a buyer, but only in energy, commodities, and technology, and of course in emerging markets like Brazil, India, China, Korea, and Vietnam. Gold, silver and commodities have all had huge runs. My inner wimp has me in cash, waiting for better opportunities. I haven’t been playing the short side, because it’s a nightmare trying to short a liquidity driven market with interest rates at zero. There is no return on low risk investments now. Capital always moves to risky assets when interest rates are zero. Just look at Japan in the 1980s. There PE multiples soared from 10 to 100 purely driven by liquidity. For the last three years of that run the fundamental analysts were left twisting slowly in the wind. Artificially low interest rates boost asset prices to artificially high prices. It always ends in tears, but can play out for a while. You want to have an asymmetric risk reward metric in your favor, as we did in March of this year. Now, we don’t have that.

The next downward move in the markets will more likely be due to disappointing economic data, earning misses, etc., not due to a total collapse of the system. We may sell off, but I don’t think it will be to new lows. It’s hard to see new lows with interest rates at zero. Instead, I see the “square root” recovery scenario mentioned earlier. The market may start drifting lower as people start seeing this possibility. That might set up a trading range for the S&P 500 which could last for years, something like 800-1,200. During the nineties, Japan peaked at ¥39,000, then traded in a ¥20,000-¥25,000 range for five years, before the final collapse to ¥7,000. That’s one scenario for the US.

Ilene: You’ve had an amazing career. Let me ask you about some of the people you’ve interviewed. What was Ronald Reagan like?

Mad Hedge: Although I never agreed with him politically, you couldn’t help but like the guy. He always had a joke ready. He was a lot smarter than he let on.

Ilene: And Margaret Thatcher, the prime minister of Britain?

Mad Hedge: Her nickname as “The Iron Lady” was well deserved. She could stare holes right through you. She treated journalists like a disapproving school teacher, which of course, she was.

Ilene: How about the terrorist leader, Yassir Arafat, of the PLO?

Mad Hedge: His body guards almost shot me when I reached to turn over a cassette in my tape recorder. I always thought he was a terrible leader. That is why the Palestinians never got anywhere, and why the Israelis left him alone.

Ilene: Meeting China’s Deng Xiaoping must have been amazing.

Mad Hedge: I am 6’4” and he was only 4’9”, so of course there were plenty of opportunities for humor. I could never envision this guy going on the Long March. He had a tremendous wit. Someone asked him why China kept its borders closed, and wasn’t this an imposition on human rights. He said if he opened the borders, the surrounding countries would get flooded with people. He asked “How many Chinese do you want? 20 million? 30 million?” I also met Zhou Enlai during the Cultural Revolution. He was a brilliant man, the last man on a bell shaped curve of 500 million.

Ilene: I read somewhere that you interviewed four US Secretaries of the Treasury.

Yes, Miller Reagan, Schultz, and Brady. And I visited the French chateau of a fifth, C. Douglas Dillon. I keep a collection of dollar bills they signed.

My goal in life was always to get in the way of history, and let it run me over. It’s been an amazing life. I wouldn’t trade it for anything.

Ilene: What about Apocalypse Now?

Mad Hedge: I happened to be in town to interview Ferdinand Marcos, the president of the Philippines. If you look hard, I’m in the USO scene. Most of the other “GI’s” in that scene were European and Australian hippies rounded up from the Youth Hostels of Manila by Francis Ford Coppola’s agents. Good luck, though. I was a lot younger and thinner then.

Ilene: Thanks a lot. It’s been great talking to you.

U.S. Pushes China for Yuan Appreciation

The U.S. called on China to let the yuan rise before President Hu Jintao’s planned January trip to Washington, setting a deadline for results after Group of 20 leaders failed to reach a broad agreement on currencies.

Hu’s U.S. visit “will be an important time to look at exactly what the quantum of progress has been” on China’s currency reforms, National Security Adviser Thomas Donilon told reporters today in Yokohama, Japan. The pace of the moves is a “sovereign decision” and the U.S. “will certainly be looking.”

The U.S. push for quick action comes a day after President Barack Obama ramped up his criticism of China’s policies, calling the yuan “undervalued” at the G-20 Summit in Seoul. Leaders failed to agree on a remedy for economic imbalances that endanger the global recovery as they clashed over whether Chinese or U.S. policies were more to blame.

“No nation should assume that their path to prosperity is simply paved with exports to America,” Obama said yesterday in a speech at the Asia-Pacific Economic Cooperation forum in Yokohama, which he attended along with Hu after the leaders left Seoul.

The yuan has risen about 3 percent against the dollar since June 19, when China said it was allowing a resumption of appreciation that was frozen in 2008. China has $2.65 trillion of foreign currency reserves, more than double any other country.

‘Steady Pace’

“China will continue to improve its currency reform at a steady pace,” Hu told reporters in Yokohama.

China ran up a $201 billion trade surplus with the U.S. in the first nine months of this year, more than the U.S. deficit with the next seven-largest trading partners combined, Commerce Department data show.

Chinese policy makers say the Federal Reserve’s monetary easing policy poses risks for global financial stability. More capital inflows to the region will fuel asset bubbles and inflation, Jin Zhongxia, a deputy director general of the international department at the People’s Bank of China, said yesterday.

“Major reserve-currency issuing countries excessively print money to get out of their own economic difficulties, posing a policy dilemma for emerging economies,” Jin said in Macau, without naming any countries.

‘Indicative Guidelines’

The G-20 said emerging markets facing a surge of capital inflows can adopt regulatory steps to cope, offering them cover to limit currency swings as the U.S. adds $600 billion of liquidity. The group’s finance ministers will work next year on a set of “indicative guidelines” designed to identify large economic imbalances and how to fix them, according to a joint statement released at the Seoul summit.

“We averted, hopefully, a currency war,” Mari Pangestu, trade minister for Indonesia, a G-20 member, said in an interview with Bloomberg Television. Currency issues “cannot be solved bilaterally or unilaterally,” she said.

Obama and Hu were among 21 leaders meet at APEC in Japan following two days of talks at the G-20 summit.

The yuan declined 0.2 percent to 6.6370 per dollar as of 5:30 p.m. two days ago in Shanghai, even after the People’s Bank of China set the reference rate at 6.6239, the strongest level since a peg ended in July 2005, according to the China Foreign Exchange Trade System. The currency has climbed 0.3 percent in the past five days, the second weekly gain.

Some Japanese business leaders have backed China’s currency approach on grounds that an abrupt change could send ripples through the global economy.

“China’s current policy of moving gradually, carefully, step by step to a more flexible exchange rate regime is really the right idea,” Junichi Ujiie, chairman of Keidanren, Japan’s biggest business lobby, said in an interview with Bloomberg Television yesterday. Moving quickly would “cause confusion in China’s economy, which is going to be really hard for the global economy.”

RockMelt Vs. Flock

The Internet is like space. Hell, it even has its own term, “Cyber Space,” and it - just like space - goes on forever. The four most popular Internet trends are; social networking, E-Mail, blogging, and internet shopping.

The Internet has grown along with these and many more features. Just recently in the past few years, it has evolved to help link them all together via - these little pestering things we all get invites for - apps. Link your Facebook, Twitter, Digg, Gmail, Blog, RSS feeds, and everything else to one account. But what happens when Chromium (An open source browser engine developed by Google) - changes all that?

Well it has. Chromium has helped to create one of the fastest & rapidly growing popular browsers (Google Chrome.) But thanks to this engine, other browsers have been birthed. Two of which are what we in the Technology world have labeled “Social Media Browsers." These are browsers that link everything; Facebook, Twitter, Email and so on, within the browser itself. These two revolutionary browsers I speak of are Flock & RockMelt.

Let’s start with Flock. This browser was originally built using Mozilla open source code that Firefox runs off of. But now runs on the Chromium engine. The installment of this browser is as simple and exactly the same as installing Chrome. But once you launch Flock, for the first time, you have the option of importing all your favorites, bookmarks, and other information.

It also has its own account feature. The Flock account keeps all your social networking and account information secure. It allows you to link your accounts to a general or master account. So you must log in to a master account (as it were) to access your social stream. Compared to Chrome itself, and taking into account all the streaming social network information this browser does and can take in, I’d say it’s pretty fast.

The only thing I don’t like about this browser is that upon importing all your information, I found my Bookmarks and the like to be a little… screwy. But hey nothing is perfect, especially if it is Internet related!

Next is my favorite browser. Obviously you can tell which one I like most already, and which one essentially “Wins” in this article. RockMelt is another Chromium powered browser. It has recently entered its public Beta stage. All you have to do is connect your Facebook profile via the RockMelt website, then wait to receive a Beta invite within the next few days. Most people seem to get it within 42 hours.

Then once you get the Beta invite, there is the standard Chromium browser set-up. Then here comes the catch, you pretty much have to give RockMelt supreme control of you’re Facebook. Admittedly I did think twice before hitting the approve button. Overall the RockMelt browser shares a lot in common with Flocks design, Menu, and User Interface.

There are a few UI problems, for example your social stream (Called EDGE) can disappear and become unavailable from time to time. The Twitter feed goes dead and at times can be completely useless. But all this comes down to is that it's a Beta program and still and has a lot of room to grow, improve - and has serious potential.

At the end for the day, I would suggest both of these browsers to anyone involved in the social media world, of the internet.

I give Flock a 3.5 out of 5, for a very original idea, and great features, that kept me browsing.

I give RockMelt a 4 out of 5, for a slim design, great integration and customization.

Gold/Sliver Bulls

Gold/silver bulls are getting sloppy again, now at $1410/ $27.73. Silver has been the catalyst for this entire two-month leg up, crowning a whopping $10 move during this time frame. At the start of this Tuesday's session, however, the Bulls ought to be cautious. Just like with that $3.50 Dec NatGas print early in Oct.25 session - the daily charts are going parabolic!

I would be heeding the following alarming factors, as Gold and Silver futures sit at record highs tonight:

1. USD has been firming in last couple of sessions - but Gold and Silver still rallied to records. Bulls will argue that this a positive divergence, pointing to "independent strength". I suspect that this, in fact, may be pointing to forced short-covering; and thus, less of the forced short-covering remains to be executed!

2. Platinum and Copper did not follow Gold, Silver and Palladium's move to new highs Friday and Monday. I would note muted response in Crude and grains as well. The only other commodities that continued parabolic were the leading stars of the period: Cotton and Sugar. Again, another sign of forced short-covering well in progress.

3. Significant news of QE2 and elections are done with, and precious metals have just tacked on more gains.

4. Chartists know that, following a lengthy run, a commodity that continues parabolic at week's start risks a powerful intra-week reversal. Those types of "outside reversals" on the Weekly are much more potent, in my observation, than the ones on Daily. When Gold futures chart-painted that "shocking" intra-day reversal from $1366 to $1326 on October 7, that made me temporary Bullish. I shall not be Bullish if something like "outside reversal" will be painted on Weekly chart.

5. Another chart complication will be caused by semi-holiday week, with Veterans Day shutting the Treasury markets on Nov.11, and taking bank and Fed personnel out of the office.

p.s. Had lunch with a formal colleague, who has been super bullish on Gold for many years, the first thing he said to me is "congratulations", before I asked what for, he said: look at Gold price, and you have gold, right? because all Chinese buy gold, stereotype!!

Gold is Indeed One of the Dollar’s Rivals

A few sentences about gold toward the end of a column by Robert Zoellick in today’s FT are drawing much attention. I doubt very much if the World Bank President has in mind a return to the gold standard, though goldbugs and critics alike are talking as if he does.

Even if one placed overwhelming weight on the objective of price stability — enough weight to contemplate a rigid straightjacket for monetary policy — gold would not be a suitable anchor. The economy would be hostage to the vagaries of the world gold market, as it was in the 19th century: suffering inflation during periods of gold discoveries and deflation during periods of gold drought. This is well-known. I am confident Zoellick understands it. (He and I were in the same macroeconomics seminar at Swarthmore College in the 1970s.)

I think he is making another point. The world is moving away from a monetary system in which the dollar is the overwhelmingly dominant international reserve asset. The dollar’s share of international reserves has been declining ever since Richard Nixon unilaterally ended the Bretton Woods system in 1971. The dollar’s unique role is not an eternal god-given constant of the universe, any more than it was for pound sterling. The US currency of course replaced the pound in the first half of the 20th century, with a lag of 25 years or more after the US surpassed the UK economically.

Will some asset replace the dollar, then? No, not a single asset. But we are probably moving to a system where there will be as many as a half dozen international reserve assets. First, there is the euro. Despite the serious troubles facing it this year, the euro has been a competitor for the dollar since it came into being 11 years ago. Both the yen and the Swiss franc have to some extent played safe haven roles during the last three years of global financial turmoil. The pound is not out completely. Some day the renminbi will be added to the roster of major international currencies, when China’s financial markets are sufficiently developed and open. Even the SDR (special drawing right) came back from the dead in 2009.

And, yes, gold too has re-joined the world monetary system. Gold was seen as an anachronism as recently as a couple of years ago. The world’s central banks had been gradually selling off their stocks. But all that changed in 2009. The People’s Bank of China, the Reserve Bank of India and other central banks in Asia have bought gold. Understandably, they want to diversify their reserves. It appears that central banks have stopped selling gold even among advanced countries and that aggregate gold reserves have risen over the last year. This is a multiple reserve asset system.

Momentum Moving to Asia Pacific

Janus is targeting the Asia Pacific market for investments as well as new fund customers.

In an interview with Asian Investor, chief Richard Weil said expanding in the region is at the top of his agenda. He sees the launch of products catering to Asian investors as key, acknowledging that Janus does not currently have especially compelling regional offshore offerings.

Currently, 8% of Janus's $160.8 billion in assets is based outside the U.S., but the company's goal is to raise the level to 20% to 25% within five years, Weil said in the interview. Part of the strategy entails broadening the distribution network and adding investment resources, starting with the addition of one or two portfolio managers and three or four analysts somewhere in Asia most likely next year, he also said.

Janus has offices in Tokyo, Hong Kong and Melbourne, where 35 employees attend to client servicing, compliance and sales, but nearly all of its portfolio managers and analysts are based in the U.S.

The product path will progress from global to emerging-markets funds, then regional equity and fixed-income offerings, Weil tells Asian Investor.

Janus is also positioning itself for more Asia Pacific investments by its U.S. customers, Weil said. He predicted that U.S. investors will shift assets overseas in greater numbers as they come to terms with the U.S.'s diminished global power. The realization will foster a deeper understanding on investors' part of regional differences and individual country performance, he also said.

Consistent with that view, Janus last week rolled out three global funds: the Emerging Markets Equity Portfolio, Global High-Yield Portfolio and Global Investment Grade Bond Portfolio.

Quote.com vs. cn.Quote.com

Just noticed today that quote.com has a China site now: cn.quote.com. It lists Shanghai SE, Shenzhen SE, A shares, B shares, Government Bond, as well as Hongkong.

This is my first time seeing a sleek US site listing Asian ticker, they did make modificiation though, the color is red when it goes down, not so in China, they are up in Red and Down in Green. I guess color would flip as well when it is moved to the other side of the earth.

The Focus Hocus-Pocus

Democrats, declared Evan Bayh in an Op-Ed article on Wednesday in The Times, “overreached by focusing on health care rather than job creation during a severe recession.” Many others have been saying the same thing: the notion that the Obama administration erred by not focusing on the economy is hardening into conventional wisdom.

But I have no idea what, if anything, people mean when they say that. The whole focus on “focus” is, as I see it, an act of intellectual cowardice — a way to criticize President Obama’s record without explaining what you would have done differently.

After all, are people who say that Mr. Obama should have focused on the economy saying that he should have pursued a bigger stimulus package? Are they saying that he should have taken a tougher line with the banks? If not, what are they saying? That he should have walked around with furrowed brow muttering, “I’m focused, I’m focused”?

Mr. Obama’s problem wasn’t lack of focus; it was lack of audacity. At the start of his administration he settled for an economic plan that was far too weak. He compounded this original sin both by pretending that everything was on track and by adopting the rhetoric of his enemies.

The aftermath of major financial crises is almost always terrible: severe crises are typically followed by multiple years of very high unemployment. And when Mr. Obama took office, America had just suffered its worst financial crisis since the 1930s. What the nation needed, given this grim prospect, was a really ambitious recovery plan.

Could Mr. Obama actually have offered such a plan? He might not have been able to get a big plan through Congress, or at least not without using extraordinary political tactics. Still, he could have chosen to be bold — to make Plan A the passage of a truly adequate economic plan, with Plan B being to place blame for the economy’s troubles on Republicans if they succeeded in blocking such a plan.

But he chose a seemingly safer course: a medium-size stimulus package that was clearly not up to the task. And that’s not 20/20 hindsight. In early 2009, many economists, yours truly included, were more or less frantically warning that the administration’s proposals were nowhere near bold enough.

Worse, there was no Plan B. By late 2009, it was already obvious that the worriers had been right, that the program was much too small. Mr. Obama could have gone to the nation and said, “My predecessor left the economy in even worse shape than we realized, and we need further action.” But he didn’t. Instead, he and his officials continued to claim that their original plan was just right, damaging their credibility even further as the economy continued to fall short.

Meanwhile, the administration’s bank-friendly policies and rhetoric — dictated by fear of hurting financial confidence — ended up fueling populist anger, to the benefit of even more bank-friendly Republicans. Mr. Obama added to his problems by effectively conceding the argument over the role of government in a depressed economy.

I felt a sense of despair during Mr. Obama’s first State of the Union address, in which he declared that “families across the country are tightening their belts and making tough decisions. The federal government should do the same.” Not only was this bad economics — right now the government must spend, because the private sector can’t or won’t — it was almost a verbatim repeat of what John Boehner, the soon-to-be House speaker, said when attacking the original stimulus. If the president won’t speak up for his own economic philosophy, who will?

So where, in this story, does “focus” come in? Lack of nerve? Yes. Lack of courage in one’s own convictions? Definitely. Lack of focus? No.

And why would failing to tackle health care have produced a better outcome? The focus people never explain.

Of course, there’s a subtext to the whole line that health reform was a mistake: namely, that Democrats should stop acting like Democrats and go back to being Republicans-lite. Parse what people like Mr. Bayh are saying, and it amounts to demanding that Mr. Obama spend the next two years cringing and admitting that conservatives were right.

There is an alternative: Mr. Obama can take a stand.

For one thing, he still has the ability to engineer significant relief to homeowners, one area where his administration completely dropped the ball during its first two years. Beyond that, Plan B is still available. He can propose real measures to create jobs and aid the unemployed and put Republicans on the spot for standing in the way of the help Americans need.

Would taking such a stand be politically risky? Yes, of course. But Mr. Obama’s economic policy ended up being a political disaster precisely because he tried to play it safe. It’s time for him to try something different.

Mr. Bloomberg: "I never met in my life such an arrogant man (Obama)

HONG KONG — Criticizing China was a popular campaign tactic for Democrats and Republican candidates alike in many campaigns this year, but Mayor Michael R. Bloomberg of New York was quick to leap to China’s defense on Saturday.

“It is very dangerous for us as a society — I’m speaking of America — to focus on blaming others, because what you do then is you don’t focus on your own practices,” Mr. Bloomberg said at a news conference here.

He spoke after assuming the chairmanship of a coalition of 40 city governments around the world concerned about climate change.

Mr. Bloomberg was openly skeptical of the Obama administration’s decision on Oct. 15 to open a broad investigation into whether China violated World Trade Organization rules by subsidizing its exports of solar panels and other clean-energy products to the United States and by restricting imports.

“Let me get this straight,” Mr. Bloomberg said, “there is a country on the other side of the world that is taking their taxpayers’ dollars and trying to sell, subsidize things so we can buy them cheaper and have better products, and we’re going to criticize that?”

He said the United States also subsidized “an enormous number of industries.”

The World Trade Organization has restrictions on many kinds of subsidies. But its toughest bans are on export subsidies, in which a government tries to use its money to help its country’s companies buy market share in another country.

White House officials have acknowledged that the United States has subsidized the research, development and deployment of clean-energy technologies. But they have denied that the United States was subsidizing their export.

Zhang Guobao, the director of China’s National Energy Administration, strongly criticized the American investigation of Chinese practices at a news conference on Oct. 17 and emphasized that the United States had clean-energy subsidies; he did not draw a distinction between domestic subsidies and export subsidies.

Mr. Bloomberg also did not make that distinction. But he said some trade disputes could have merit.

“It isn’t that I think there isn’t some justification to some of these trade disputes,” he said, “but I think it is so dangerous for America” to lose its focus on bigger issues. Mr. Bloomberg added that he believed Chinese people who had ideas for great new businesses should be allowed to immigrate to the United States.

Mr. Bloomberg praised China for showing a much greater interest lately in environmental protection, even as he criticized the country for having allowed severe water pollution and other problems.

The mayor disavowed again on Saturday any interest in pursuing the presidency. He expressed sympathy for the challenges President Obama was facing, without providing specifics, and talked repeatedly about how attractive it was to be mayor.

In New York, the mayor’s office offered a terse comment on Saturday over a remark that Rupert Murdoch said Mr. Bloomberg had made about Mr. Obama after playing golf with the president over the summer.

In an interview with The Australian Financial Review, Mr. Murdoch said that after the outing on Martha’s Vineyard, Mr. Bloomberg “came back and said, ‘I never met in my life such an arrogant man.’ ”

Jessica Scaperotti, a spokeswoman for Mr. Bloomberg, said in an e-mail that “the mayor remembers the conversation differently. As he has said many times, he believes all Americans should be rooting for the president to succeed.”

The White House press office did not respond to requests for comment.

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Chart of JPY looks set-up for BOJ intervention

here would be implication for many other contracts as well (for example bonds and metals), if such were to occur early next week.
Without expressing any opinion on this, I'd point out that there is a Japanese stock ETF which hedges out the Yen/$ exposure. So if you believe that the BOJ will take steps that pushes up the Nikkei AND the Yen will decline against the Dollar too, then buying some DXJ is a good vehicle for expressing this view.

(There are lots of other ways to express this dual view, but this is the simplest way for ETF traders.)
YCS [pro shares ultra short yen] would be a more aggressive way to play the imagined scenario….

This doesn't have much to do with hedging the exposure or this particular ETF, but I have not seen a discussion of the following anywhere so I'll pose this as a question. If you look at the composition of Nikkei-225 you see that a large percentage of it is in these groups:

Foods, Textiles and Apparel, Pulp & Paper, Chemicals, Oil & Coal Products, Rubber Products, Glass & Ceramics, Steel Products, Nonferrous metals, Machinery, Electric Machinery, Shipbuilding, Automotive, Precision Instruments, and Other Manufacturing.

It seems like my favorite Central Banker has successfully unleashed a worldwide raw materials inflation cycle, measured in whatever currency you chose. Given that Japan imports so much of its raw materials and so do many of the countries where it now chooses to do some of its manufacturing, how can what's about to happen, even if the final demand somehow rises, be good for Japan?

Harvard Squash King: Victor Niederhoffer

The first time I read about Victor Niederhoffer was from a featured article in New Yorker, I wasn't particularly interested in his trading strategy, nor was impressed by his trading record. What really made my jaw dropping was his track record of Squash record, after holding number 1 seed for all the years he studied in Harvard, he kept winning in almost every professional clubs he belonged too. In the end, no club wanted to accept him!

Though I never study his trading theory, I do visit his site every day, not to read investment related posts, but everything sports associated. He is very into Ping Pong lately and often compares Squash with Ping Pong. another sport I am very fond of.

To Squash, To PingPong, To Victor!

G20 Meeting in Korea

Korea may have an opportunity to exercise historic leadership, when it chairs the G-20 meeting in Seoul, November 11-12. This will be the first time that a non-G-7 country has hosted the G-20 since the larger, more inclusive, group supplanted the smaller rich-country group in April of last year as the premier steering committee for the world economy. With large emerging market and developing countries playing such expanded economic roles, the G-7 had lost legitimacy. It was high time to make the membership more representative. But there is also a danger that the G-20 will now prove too unwieldy, in which case decision-making might then revert to the smaller group.

When countries like China and India used to demand a larger voice in world governance based on their large populations, they did not get very far. Substantive power in multilateral governance is allocated according to the Golden Rule: “He who has the gold rules.” But after a few decades of miraculous economic growth rates they now have the economic heft. China is now larger economically than Japan or Germany. Brazil is also one of the seven largest economies.

Beyond GDP, we have recently seen a historic role reversal, in which debtor-creditor patterns have changed. Many developing countries, breaking historic patterns, took advantage of the global boom of 2003-2007 to achieve high national saving rates, particularly in the form of strong government budgets, while the advanced countries did not. As a result, the debt levels of the top 20 rich countries (debt/GDP ratios around 80%) are now twice those of the top 20 emerging markets. And it is rising rapidly. A number of emerging market countries now have higher credit ratings than a number of so-called advanced countries. A stronger fiscal position is one of the reasons that countries like China could afford to undertake large and sustained fiscal stimulus in response to the 2008-09 global recession. The United States and United Kingdom, by contrast, had wasted the preceding expansion running budget deficits, and hence by 2010 had come to feel heavily constrained by their debts.

It is understandable if Korea views its hosting of the G-20 as another opportunity for marking its arrival on the world stage (as when it hosted the Olympics) or for consolidating its status as an industrialized economy (as when it joined the OECD). But it should make more of its opportunity than this. Korea should seize the chance to exercise substantive leadership. Otherwise, the risk is that its period in the chair could appear like a replay of the chaotic Czech presidency of the EU in the first half of 2009, which confirmed the feelings of some in the larger European countries that it was a mistake to let smaller countries take their turns behind the wheel.

Korea can serve as a bridge between the G-7 and the developing countries. But chairing a successful meeting will be a challenge, with respect to both meeting management and substantive issues.

With regard to managing the meeting, the challenge comes from the size of the group. There is always a tradeoff between legitimacy and workability. The G-7 was small enough to be workable but too small to claim legitimacy. The United Nations is big enough to claim legitimacy but too big to be workable. The latest evidence of this was the Conference of Parties of the UN Framework Convention on Climate Change in Copenhagen last December. The UNFCCC proved a totally ineffectual vehicle, in part because small countries repeatedly blocked progress. President Obama was able to make more progress by spending a few minutes in a room with a few big emitting countries than the delegates had achieved in two weeks.

The G-20 has enough legitimacy for its purpose — which is more limited than the purposes of formal institutions such as the UN, IMF, and WTO. It accounts for 85% of the world’s GDP, for example. But it is too big to be workable as a steering group. A principle of multilateral talk-shops is that conversation is not possible with more than 10 in the room. With 20 delegations, each reads prepared statements; there is no give and take and the communiqué is a watered down least-common-denominator press release. Not only does the G-20 have more than 10 delegations; it actually has more than 20.

The G-20 needs a smaller informal steering group within the steering group, a G-6 or G-9 within the G-20. It could meet in the evening before the main G-20 meeting and discuss how to organize the discussion in the larger group.

Who would be in the G-6 or G-9? It would be unwise to be too specific at this point. Nevertheless, the US, Japan, and Europe (represented perhaps by the EU Commission), must be there on the rich-country side; China, India, and Brazil must be there on the developing-country side. Of course the pressure to expand is always irresistible. Europe could be represented by both the U.K. and euroland. In Seoul, Korea has to be there as the host. Who would be the 9th country in the G-9? It should be the country of which the person reading this blog post is a citizen.

What about the substance of the meetings? The group will discuss whatever the bigger countries consider it most useful to discuss at the time. Five possible topics include:

•At long last, giving more seats on the IMF executive board to big emerging market countries, in proportion to their rising economic clout,offset by consolidation of some of Europe’s seats.
•More financial regulatory reform, such as coordination of any small taxes or penalties that members want to apply to risk-taking banks.
•Global current account imbalances. Perhaps there will be a statement agreeing that large current account deficits or surpluses tend to lead to problem (absent some good economic justification), that exchange rates and budget deficits both bear some responsibility for current large imbalances, and that the burden of adjustment should be born by neither one alone, but rather by both.
•Macroeconomic exit strategies. I personally would favor an articulation of the proposition that concrete steps toward long-term fiscal consolidation in each country need not require premature withdrawal of current fiscal stimulus. An example would be to raise the future retirement age or take other steps today to reform public pensions, even while simultaneously enacting some short-term stimulus in the US and UK.
•Moving toward a new agreement on climate change to take the place of the Kyoto Protocol after 2012. Korea is in a good position to lead, as essentially the first post-Kyoto country to accept emission targets.
Don’t judge the outcome of the meeting by what appears in the media. Press reviews usually pronounce such summits a let-down. But occasionally such meetings are important, in ways that are often not clear until later.

Consider the London G-20 meeting of April 2009. It was not obvious at the time that it had been a success in terms of substantive policies. Observers even compared it to the infamous failed London Economic Summit of 1933, which was a way of saying that the world had not learned the lessons of the Great Depression. But the 2009 meeting appears far better in hindsight. Looking back on 2009, fiscal stimulus turned out to be more widespread in 2009 than one might have guessed. Similarly, global monetary policy was easy, avoiding another big mistake of the 1930s. The G-20 unexpectedly agreed to triple IMF resources and bring the SDR back from the dead. Even in the area of trade policy, despite fears of protectionism, the outcome was not bad at all by the standards of past recessions, let alone in comparison with the Smoot-Hawley tariff of 1930. Overall, policy-makers’ immediate response to the global recession in 2009 did not repeat the mistakes of the early 1930s.

Currently, however, the advanced countries are in danger of repeating the mistake that President Franklin Roosevelt made in 1937, when he cut spending prematurely and sent the US economy back into recession. Perhaps the G-20 will be a venue in which the big emerging market countries can remind the U.S. and the U.K. of the lesson they once knew but have now forgotten — what it means to run a countercyclical fiscal policy.