It seems as though our fearless leader never stops talking about international trade. International trade was a big issue in his campaign and bilateral renegotiation of existing trade deals remains reasonably high on the new administration’s agenda along with a fancy new border tax (we’ll get to that in a moment).

However, it is not international trade in its totality that Trump is obsessed with as much as one offensive part of it – the trade deficit. But once again, though, it is not the trade deficit in its entirety – the $500 or so billion in all its majesty – that seems to get Trump upset as much as each, little, bilateral trade deficit, especially those with evil, low-cost labor force countries, e.g. China and Mexico. And in his misplaced focus on bilateral trade relationships, Trump shows the world just how little he knows about trade and how ill-equipped he is to make important economic decisions on behalf of his country.

Apologies ahead of time if parts of this sound like an economics textbook. But then again, maybe Trump should read an economics textbook. Anyway…

Trade in goods and services – loosely known as the trade balance, is just one part of the Balance of Payments which accounts for all the transactions a given country has with all the others. There are two major sections to the Balance of Payments – the current account (which includes the trade balance) – and the capital account. How foreign transactions get classified – which of these two accounts they go into – makes sense mainly to economists. If the US sells a tractor to China, the sale will be classified as an export and will get counted in the current account as part of the trade balance. On the other hand, if China builds a factory in the US, and the US sells China land, labor, legal services, materials etc., these sales will be classified as an investment and will get counted in the capital account. If the U.S. sells a foreigner a government bond, the sale will get counted in the capital account.

For the country as a whole, and certainly for its president, the important issue is how much America sells in total, regardless of account, to the rest of the world. Exporting tractors is nice but having a new factory employing lots of folks is just as nice (as is having someone buy your government bonds). There need be no prejudice favoring a current account/trade balance type of sale over a capital account sale, a realization that starts to explain why focusing on the trade balance in isolation makes no sense at all.

Looking at the trade balance as part of the bigger picture also explains why trade deficits, despite their poor reputation and Trump’s fixation, are not bad. They are, in fact, neutral. A trade deficit is the mirror image of a capital account surplus, i.e. more money coming in to build factories (or buy government bonds) than is going out for the same reason. A small country attracting a disproportionate amount of money into its stock market and running a trade deficit is vulnerable to the money leaving. In this case, the trade deficit is a symptom of a risky situation. A large stable country running chronic trade deficits and diversified capital surpluses is not in any immediate economic danger and its trade deficit is just part of the scenery.

Illustrating their tendency towards incoherence, most commentators like capital account surpluses. The reputation of such surpluses in the media and in political circles is excellent. But – and Mr. Trump might want to make a special note of this, since it is his administration’s bonds foreigners are buying – you can’t have the one, a wonderful capital account surplus, without the other, a nefarious trade deficit.

If focusing on the trade balance in isolation makes little sense, fretting over individual trade deficits with single countries is an absurdity. Their size alone, compared with balance of payments flows, should disqualify them from attention. Mexico’s trade surplus with the U.S. was worth $63bn last year. Total current account flows in Q4 2016 annualized was $6,880bn. But more significantly, in a world of tangled supply chains and re-exports where the value added to create a pencil can come from a dozen countries, measuring a trade deficit with a particular country is meaningless.

Of course, the other important issue is how much America wants to buy, in total, from the rest of the world. Here is where the “balance” part of the Balance of Payments comes in. Theoretically, these two, very large purchase orders could match, or balance, leaving the Federal Reserve with nothing to do that day. In practice, the two do not match and the Federal Reserve has to decide whether it wants to print U.S. Dollars, dip into its foreign exchange reserves or adjust the value of the exchange rate or some combination thereof to make the Balance of Payments balance.

Central banks, particularly of smaller countries whose Balance of Payments accounts for a large percentage of GDP, periodically find themselves resorting to extreme measures in order to address a Balance of Payments that refuses to balance. Central banks in this situation usually end up being forced into a humiliating devaluation of their currency. However, the U.S. is not subject to these sorts of problems. The U.S. is the very epitome of the large stable country above running a trade deficit as part of the scenery.

Perhaps Trump should ponder the following: The U.S. has not run a trade surplus for 35 years. The largest trade surplus since 1950 was in 1975 when it equaled an inconsequential 1% of GDP. Today’s deficit is a manageable 2.6% of GDP. In 1975, the U.S. trade weighted Dollar index stood at 100. Today it is 94. The stability of the U.S. Dollar over the last 42 years is based in part on its role as the world’s reserve currency but it also is an indication that the two large purchase orders, how much America wants to buy from the world and how much the world wants to buy from America, have largely stayed in balance. The U.S. Balance of Payments per se is not broken. It does not need to be fixed.

Trump wants faster GDP growth and more manufacturing jobs and has grabbed hold of the one thing he’s heard about, America’s trade deficit with Mexico, as the bogeyman to defeat in order to get them.

Here is what he should be grabbing. America’s capital inflows are not really financing many new factories – they are financing government spending (foreigners buying U.S. bonds), which is not nearly as productive. America could certainly be attracting more foreign capital for direct investment, achieving fast productivity growth, incentivizing higher levels of domestic private investment and enjoying higher employment- as well as less crowding–out by the public sector. But the way to get these things is not by attacking innocent, by-stander trade deficits. It is by closing loop-holes and lowering overall corporate and individual tax rates; it is by raising the retirement age and eliminating the cap on H-1B visas; it is by thoughtfully eliminating regulations that discourage competition; it is by abolishing taxes on labor. Etc.

And if the president wants these things, the last thing he should consider is a border tax.

 

 

Time and again since the end of the financial crisis, economic and political bigwigs have lamented the mysterious inability of monetary and fiscal policy to galvanize moribund economies. I don’t need to mention which economies. You know who you are.

Nowhere have these lamentations been heard more frequently than in Japan. (Oh, I did mention one of you.) The debate has raged in Japan over the last year. Interest rates are tweaked down as low as they can go. Should the Bank of Japan try negative interest rates? Maybe -0.1%? How about a little lower? Should Kuroda increase his pace of bond purchases? Maybe $733bn p.a. (the current rate of purchases, worth about 16% of GDP) is not enough? What about a tranche of helicopter money? And, yes, there has been a fiscal stimulus package of some sort every year since 1993, but maybe just one more will do the trick? How big should it be? Is $273bn “bold” enough?

How hard have Japan’s authorities tried to make these policies work? Very hard.

Since the beginning of 2012, when things really got going, total assets at the Bank of Japan have risen 3-fold to $4.4trn or just over 100% of GDP and right around the level of assets at the Federal Reserve, a central bank in charge of an economy four times as big. Meanwhile, on the fiscal policy side, the government of Japan has been running a very generous budget deficit of between six and nine percent of GDP, every year over the last seven.

Have these policies worked? No, they have not.

GDP growth in Japan has averaged 0.6% p.a. over the last four years. Industrial production has been shrinking at a rate of 1.4% p.a. since 2014. The CPI ex food and energy, last seen at 0.3% in July, is on a downward path. Real incomes growth, after enjoying a brief period in positive territory in 2015 as a result of the weak yen, recorded a decline of 1.8% in July. Wages are growing, but at a modest 1.4% rate.

The only qualified win for the Keynesian bigwigs has been the yen. The yen did respond very nicely to the expansion of the Bank of Japan’s balance sheet, falling from 78 to 125 vs. the U.S.Dollar mid-2012 to mid-2015, causing a significant increase in corporate profits growth over the same time period. Sadly though, Japan is also banker to the world (it is a net international investment surplus country) and as a result, the yen is a safe haven currency. Thus, from time to time, domestic monetary policy is overwhelmed by the exigencies of foreign investors piling into the yen because they are feeling rattled. And so it has been for most of 2016. Investors have felt rattled, the yen is back up to 102 and corporate profits growth is back in negative territory.

In our humble opinion, and in the opinion of many other free-market capitalists and maybe even Japan’s Prime Minister himself, but clearly NOT all the bigwig Keynesians, what Japan needs is not more monetary and fiscal stimulus, but deregulation. Abe’s missing Third Arrow. And in particular, it is perhaps Japan’s labor market, currently a most effective deterrent to investment and growth, which needs most deregulating.

Japan’s labor market quirks are well-known: long-term job security, seniority-based wages, company-based labor unions and a startling bias against women. Especially mothers. The impact of all these regulations is hard to measure, but we will have a go.

Labor productivity rates show that Japan’s workers produce about as much as Slovenia’s (where?) and 30% less than America’s in terms of GDP per hour worked. An under-class of non-regulated workers, who are paid badly and have no tenure, now account for over a third of total employment in Japan and are used, rather unfairly, as a buffer in recessions. The bias against mothers is a powerful factor behind Japan’s low birth-rate. Japanese women feel they have to choose between a job and a child. They cannot easily have both. Many choose the job. Only a third of mothers work in Japan and the birth-rate is 1.4 children per woman when the rate required to maintain a stable population is 2.1. As a result, Japan’s workforce is shrinking by 1m people per year.

A shrinking population is not good for growth.

Abe’s administration has dabbled in reforming other markets. The FT reports that there has been some success with agricultural co-operative reforms but we note that the price of rice in Japan is still 10x the world price and 4x the retail price in the U.S. Consensus is of the opinion that not nearly enough has been done about structural reform, even outside the politically prickly labour market, and we would have to agree.

Deregulation is tough to accomplish in any country. But in Japan, where mainstream thinking harks back to Japan’s golden age of economic growth and remembers how well Japan’s industrial policy and labour markets worked in the past, it is very difficult indeed.

Why did Japan’s unorthodox policies work so well in the past? In our opinion, serendipity had a lot to do with it. Post-war Japan was starting from scratch and if you don’t have a capital base, your capital base cannot suffer from misallocation. And that misallocation cannot then be set in stone and protected tooth and nail by wealthy, entrenched interests. Wages were very low (at the beginning of the period, at least). MITI’s focus on manufactured tradeables was perfectly timed, given the transformation of global transportation networks that was about to be turbo-charged by the fall in the price of oil.

Elsewhere, Europe was busy during this period putting in a welfare state and unionizing its labour force, thereby excusing itself as a competitor from many areas of the post-war explosion in trade. China was stumbling around in the darkness of communism and the Asian Tigers were just a sparkle in Lee Kuan Yew’s eye. That left just the US as an effective competitor. Between them, the U.S. and Japan carved up the world. By 1980, Japan and the US were the world’s two largest economies accounting for 47% of GDP. Today they account for just under 30%.

The economies of scale, access to capital, insulation from domestic competitive forces and shelter from shareholder pressure for short term profit maximization provided by the keiretsu certainly contributed powerfully to Japan’s success. So did a well-educated work force. However we cannot help thinking that none of these factors would have made a critical difference out of context. Could a mid-sized, war-torn economy today grow to be the second biggest economy in the world on the back of manufactured exports?

The world has changed. Industrial policy works (up to a point) if all you are doing is “catching up”. It has no place if your country has caught up and needs to innovate. The Japanese men and women trapped as lifers in dead offices of large corporations need to be “let go” so they can do the innovating. Japan should move to pay for performance. And if a country running a budget deficit worth 6% of GDP really wants a “shock and awe”-sized fiscal stimulus, it should try cutting the corporate tax rate to an internationally competitive 25% – and then to a game-changing 20%.

Those nostalgic for Japan’s “economic miracle” need to recognize that the policies that brought it about cannot engineer a second economic miracle in today’s world. No amount of fiscal and monetary stimulus can change that. Abe needs to aim at the labour market and let loose his Third Arrow.

And the Keynesians need to call it a day.

 

According to Shakespeare, some are born great, some achieve greatness and some have greatness thrust upon them. Notwithstanding the intelligence of its employees, past and present, Microsoft fits mostly in that third category. Microsoft got its head-start in the monopoly operating software business from IBM, who, presumably, did not realize what it was giving away.

In 1980, IBM, the Rolls Royce of the computer industry, purveyor of mainframes sold by an exalted internal sales force for nothing less than $15,000 a pop, decided to enter the “microcomputer” market dominated by such riff raff as Commodore, Atari, Tandy and Apple.

According to legend (corroborated by Wikipedia, although different versions of what went down exist – this is the most Shakespearean), IBM was planning to build a microcomputer around Intel’s 8086 processor, a chip that just so happened to be incompatible with the most popular operating system software of the day, CP/M. So IBM approached Gary Kildall of Digital Research, the maker of CP/M, for a tweaked version his software. Tragically, a Digital Research executive, Kildall’s wife, objected to IBM’s standard non-disclosure agreement and got upset over pricing so contract negotiations failed. IBM turned to Bill Gates who was already providing the ROM BASIC interpreter software for the new machine. Gates contacted Tim Paterson who had developed, using the CP/M-80 manual as a reference, an alternate version of CP/M called 86-DOS for use with Intel’s 8086 processor. Microsoft bought the rights to 86-DOS, IBM renamed it PC-DOS for use in its brand new microcomputer, newly christened the IBM PC, and the rest is history.

Thus, Microsoft was handed the PC operating system software monopoly by IBM for a product its engineers had not even developed themselves. No-one responsible for the creation and popularization of PC-DOS (also known as MS-DOS), Paterson, Kildall, even IBM, subsequently made anything like money Microsoft made as the middleman. Life often isn’t fair.

But the industry moved on. In 1987, Microsoft, repeating a successful past strategy, copied Apple’s graphical user interface to extend its operating system monopoly with Windows 2.0. The ubiquitous nature of the PC bestowed a related monopoly upon the lucky Microsoft in office productivity software – the sainted Microsoft Office. PC sales grew to over 350 million units in 2011 and Microsoft generated revenues of $93bn in their latest fiscal year – a record.

Which brings us to today. A lot has changed in the last 35 years but the world has really changed for Microsoft in the last ten. First off, the PC is not the indispensable computing and internet connection tool it once was. Ten years ago, just over 200 million individual computing devices were shipped world-wide. 100% of these devices were PCs and around 85% of them were graced with the Windows operating system.

This year, 2.5bn individual computing devices will be shipped but only 12% of them will be PCs. And while Windows still clings to its 85% market share of PC operating systems, it has been trounced in the new markets. Overall, Windows will be in charge of operating just 14% of the 2.5bn devices shipped this year (most of the PCs and a sliver of the tablets). Android, created by Google (a recent IPO ten years ago) will be in charge of over half – 53%. And the surviving member of the riff raff, Apple, will be operating the most expensive 12%.

The smartphone is now the world’s favourite computing and internet connection tool (75% of this year’s 2.5bn devices will be phones) and Windows is operating just 2.6% of them world-wide. In the US, Windows phones have been even more roundly rejected. Windows has a negligible 1.5% of the phone market in the US.

Naturally enough, the PC market is not really growing any more. (Retail sales clerks, marketing executives, engineers in the field all walk around with tablets now). PC sales peaked in 2011 and have been drifting down ever since. This year is especially dire – units were down 9% in Q2. Sales in the next couple of years should not be quite so bad. Expiring support for older versions of Windows should inspire some purchases in 2017-2019 and certainly the installed base is getting older. Draw down of inventory for the launch of Windows 10 this year also argues for a rebound in sales in Q4 and into next year. Nevertheless, it is hard to see the iconic, but passé, IBM PC recover its status as a growth product.

In a nutshell, Microsoft’s software products are on the things folks are not really buying any more. And they are not on the things folks are buying now.

The ex-growth characterization of the PC market means a lot to Microsoft. Although the company makes it as hard as possible to figure out what percentage of its sales and profits comes from which products, ball park figures can be pieced together from its financial statements. In fiscal 2015, about 51% of Microsoft’s gross profits came from PC software – Windows operating system and the Office suite both for commercial and consumer markets. And over the last year, revenue from PC software fell about 9%.

The management team over at Microsoft, after thinking long and hard about what to do about their problems with PC software, again turned to their trusted strategy and decided to copy what everyone else was doing. For about two years now, Microsoft has been selling us their Office suite of software as a service.

So how have things been going? Well, let’s look at the consumer market first. Astutely concluding that if they cannot sell more units, the only way to increase revenue is to raise prices, Office 365 is on offer for $7/month (single computer) with a terabyte of storage thrown in for free. Compared with buying Office 2013 at list ($150 – although it can be had all over the web for $86), Office 365 only makes sense if you are the sort of person who feels the need to upgrade their version of Word every 18 months. Or someone who cannot live without Outlook which was inexplicably left out of Office 13. As of the end of June, (and we were surprised), there were 15.2m such persons.

While this is an impressive number of subscribers, we have doubts about how many more such persons are out there. In order to get these customers, Microsoft has already cut their realized price in half over the last twelve months. Because not only is Microsoft competing with itself (Office 2013 at $86 is $1.4/month if you can live with your computer and its version of Word for five years and a free simplified version of Office is available online), but also with the myriad of competing but compatible products now available – also for free. In this competitive environment, it is inevitable that prices for Office 365 continue to fall. At $30/year, Microsoft would have a very competitive product. But at that price, Microsoft would need to have 120m subscribers (more than 7x its current subscriber base) or roughly 40% of the estimated installed base of consumer PCs world-wide to just get back to the $3.6bn in revenues Office Consumer generated last year.

So, the consumer market is a bust. What about the commercial market? The deal Microsoft is offering its commercial customers with Office 365 is considerably more attractive than the deal being offered to consumers – which is just as well because Office Commercial is a much bigger business, generating 29% of gross profits compared to just 4% for Office Consumer. On top of the Office software suite, Office 365 Commercial includes access to Exchange (calendaring and mail server software), Sharepoint (intranet, extranet, content management, enterprise social networking, business intelligence and work-flow management software) and Lync (instant messaging) plus your very own domain.

To match the features provided in an Office 365 commercial subscription, a company would have to buy, install, configure and run an Exchange server, Sharepoint server and Lync server, purchase client access licenses and hire an IT guy to look after it all. Companies are moving to Office 365 just so they can move their email systems out of their own data centers and on to Microsoft’s cloud. The new arrangement gives companies flexibility (so smaller companies can access Sharepoint applications they were previously too small to purchase by themselves) and better security. Microsoft also handles back-up. The economics seem to work for the customer base. Revenues from Office 365 Commercial were up 120% in the year ended June 2015 and accounted for almost a quarter of total Office commercial revenues.

Of course, Office 365 Commercial is cannibalizing sales of licensed software – most obviously Office licenses but also licenses of server products which include Exchange and Sharepoint. But overall sales of Office in the commercial market, Office 365 and regular licenses combined, squeaked out a gain in 2015 of 1.3%. Revenue from Office 365 more than made up for the decline in revenue as a result of fewer licenses sold. And this was so even though the run rate for Office 365 is higher than the reported revenues in 2015 and PC sales were down over the period.

The main reason for this overall sales increase is, of course, that Microsoft raised prices. Unfortunately, comprehensive price comparisons between Office 365 and licensed Office are beyond the scope of this commentary. However, Microsoft’s own CFO has contended that Office 365 represents a 30% increase in price relative to the relevant portion of current IT budgets. This is certainly a price increase but it pales in comparison with the 5-fold increase thought appropriate by the folks over at Office 365 Consumer. Moreover, we do not know what this analysis includes. Maybe it does not include all the costs involved in running a standalone database less efficiently than Microsoft. Maybe clients are happy to pay a 30% premium for less hassle and the ability to tailor their use precisely.

The second reason for the increase is that not all the revenue generated by Office 365 is cannibalized revenue. Some of it comes from new services – rent-a-server and rent-an-IT-professional. Office 365 commercial has widened Microsoft’s addressable market. How large these new markets are and how much extra revenue these new services could bring in are difficult things to estimate. But we venture to say that they are big. And only going to get bigger. And Microsoft can add all sorts of other software and services to its list of offerings with Office 365 in the future.

So by raising prices a bit and bundling in new services, converting the commercial Office customer base (c. 30% of gross profits) from licenses to software as a service is a modest growth business for Microsoft. Hooray.

(To be continued)

We recently offered up some thoughts on investment prospects for Brazilian equities. Sadly, we came out largely negative on that perpetually promising market but we did pause to consider the consequences of the country being bailed out, again, by a significant rally in commodity prices. President Lula accumulated much of the credit for Brazil’s economic boom in the early ‘00’s – and certainly, defying predictions, he refrained from defaulting on Brazil’s foreign debt in 2003 which was a good move. However, it was the massive shift in the terms of trade caused by the price of iron ore, oil and steel rising seven-fold (roughly) which, in our humble opinion, really drove growth from 2002 to 2007.

So, during our pause, we pondered the possibility of our bearish conclusions on Brazil being upended (seemingly the verb du jour) by what would be considered a largely unanticipated extended rally in commodity prices. Specifically, we started to ponder the outlook for that granddaddy of all commodity prices, the one most other commodity prices follow; oil.

Oil is ubiquitous, plentiful, cheap (at least when left untaxed) and has positioned itself persuasively as the fuel of choice for transportation globally. Lost in the controversy over its role in warming the planet is the fact that we (the generations who have lived from the beginning of the 20^th century to today) have benefited enormously from oil’s union with machinery, especially the internal combustion and jet engines, and the staggering increases in productivity –and standards of living – that this union has produced.

And although many feel queasy about burning it, there is still an awful lot of oil in the ground. Including recoverable and unconventional reserves, we have just over 4trn barrels of oil in the ground, which should last us at least another 120 years, assuming current rates of consumption.

As a commodity with high capital costs (at least for conventional oil production) and low production costs, we should expect the price of oil to be volatile and it has not disappointed us. It has made the round trip from below $20/bbl to $120/ bbl twice in the last 50 years. Almost.

The latest round trip began in 2001 with the oil price at $19.84 at year end. Over the subsequent nine years, China, Asia and other developing countries provided the growth in demand while the old Soviet Bloc provided the growth in supply, ably assisted by OPEC. While the overall growth in demand was not that high, 1.5% p.a. thanks to declining OECD demand, OPEC kept supplies tight, especially during the second half of the period. As a result, from 2007 through 2011 the market was in deficit and the oil price soared in response, peaking at just over $100 in 2011.

Then, in 2011, the market was hit with an exogenous factor – new technology. Suddenly, oil could be produced from rocks. Of course, only the US had the legal, technological, financial and regulatory frameworks in place to enable oil producers to take advantage of this new technology. So the US ran away with the industry.

In less than 10 years, the US shale oil industry went from zero to $70bn in revenue and $600bn in invested capital. After years of gentle decline, oil production in North America leapt from 14mb/d in 2010 to 19mb/d in 2014. Coincident with this increase in supply, growth in production from the Soviet Bloc subsided. But it did not matter. OPEC, loathe to give up too much market share, also increased supply so that by 2014, the oil market had added 8.1mb/d in supply vs just 5.3mb/d in demand and was solidly in a position of excess supply.

It took the oil price until the 4^th quarter of 2014 to realize its predicament. Making up for lost time, it halved in the last three months of the year. During 2015, the price has been generally weak, breaching the $40 level in August.

Demand for oil is generally thought to be fairly inelastic. Accepting for the moment that this is so, let us turn our attention to supply. How is supply going to respond to $40 oil?

The first participant to consider is OPEC, or more precisely, Saudi Arabia. Saudi Arabia wants to break US shale oil. It wants to inflict the sort of damage on shale that causes investors to give up any expectation of a predictable return on investment. It wants to keep prices low enough for long enough to staunch the flow of capital to the industry and thus eliminate the most effective competitor to emerge in OPEC’s lifetime. This tactic is not without its costs. Saudi Arabia will run a budget deficit of close to 20% of GDP this year and is rumoured to be considering devaluation.

The country, however, does have a long-term time horizon, $672bn in foreign exchange reserves and is unconstrained by the exigencies of shareholders or voters. In conclusion, it seems prudent to assume it will carry on pumping regardless of price, at least in the medium term, to “maintain market share”.

So what of US shale oil producers themselves? Low oil prices were supposed to annihilate these upstart, high cost participants. Unfortunately for the Saudis, six months after the oil price slump, only five out of hundreds of companies in the US have gone out of business. And while US production has stopped growing, plateauing at between 9.2 and 9.6mb/d for the first half of the year, it has not collapsed in the face of lower profitability.

Industry pundits have hastened to explain the industry’s surprising resilience. The most important, optimists say, is that shale oil is not high cost any more.

Lower oil prices have merely accelerated the industry’s propensity to consolidate, cut costs and use better technology – micro-seismic study, well production history and big data analytics – to drive productivity. Last year, break even in the Bakken region was thought to be $60/bbl. Today, some counties report break even of $20/bbl. Six to eight years ago, the estimated recovery factor in Bakken shale was 3-5%. Today it is 15-18%. Some believe that shale 2.0 promises ultimately to yield break even costs of $5-20/bbl – the same range as Saudi Arabia’s vaunted low cost fields.

Second, to help lower the cost curve even further, suppliers helpfully dropped their prices by 20%. Third, $40 oil was not even being felt in the first half of 2015 because hedges were still delivering effective high prices.

And lastly, delighted with the industry’s audacious response to low oil prices – self-imposed austerity coupled with high production – Wall St continued to supply capital, a whopping $44bn in equity and debt financing in the first half of 2015.

The Saudis are not amused. The Saudi Central Bank, voicing the country’s displeasure, admitted that “it is becoming apparent that the non-OPEC producers are not as responsive to low oil prices as had been thought, at least in the short run”.

And there’s the rub. In the short run. By the beginning of next year, a lot of those helpful hedges will have expired and income statements will be exposed to the harsh reality of market prices. And while oil production has held up, the drilling rig count is down big time, from 1600 in October of last year to 644 in mid-September. New wells, for future production, are not being drilled.

Moreover, as a new, technology-intensive industry, shale oil has been gobbling up external capital to finance its rapid growth. Between 2009 and 2014, an index of Bakken oil plays reported cash-flow from operations increasing from $875m to $7bn. Nice, but not enough to cover capital spending that grew from $1.3bn to $11.1bn over the same period.

And now, that same index of Bakken oil plays just lost $449m in Q2 2015 compared with reporting $288m in net profit in Q2 2014 and its debt to capital ratio stepped up from 56% to 63%. While these Bakken producers may not be as high cost as they were, they are apparently not as low cost (yet) as the optimists had hoped.

How long will Wall St be willing to wait for, and fund, the miracles in productivity required to turn losses into profits at current oil prices?

Wall St is not a very patient place and it is almost impossible to believe that funding will not feel the pinch after another quarter or two of losses. In our humble opinion, it is a mistake to assume that just because production has not been cut yet that production will never be cut.

In the old oil market, there was only one producer (apart from a flurry of activity for a few years from the old Soviet Bloc) who could increase supply in the long term – OPEC. In the new oil market there are two producers – OPEC and anyone who can frack.

This is the new paradigm in which the oil price will have to find its new equilibrium – determined by shale oil’s marginal cost of production (which is downward-sloping over time). Not low enough to choke off US production growth completely, but not high enough to justify the 9.2% p.a. rate of production growth sustained between 2011 and 2014 (which added 1.9mb/d to supply last year in a world that only wanted an extra 1.2md/d).

Ah, but what about OPEC? Yes, OPEC will have to decide how best to approach the change in its circumstances.

In one possible scenario, a self-delusional Saudi Arabia continues to try to kill off US shale once and for all by keeping prices ultra low. But, really, the Saudis already realize this is going to cost way more and take way longer that they originally anticipated. Also, they have no guarantee that there would not be a resurgence in activity (capitalism being what it is) after months, even years of $20 oil, if the market even sensed a return to the status quo ante.

This scenario, in our minds, is unlikely and, should it nevertheless come to pass, unsustainable. The Saudis are sane. This means that we eventually arrive at a second scenario where Saudi Arabia admits it cannot win a war against technological advancement, accepts marginal cost pricing, and the oil price settles somewhere between $35 and $55.

Which leaves Brazil, circling back to the original trigger for these musings, without its commodity bull market bailout – at least from oil.

Brazil lost its treasured investment grade status from S&P last week when the agency cut the country’s rating from BBB- to BB+ and maintained a negative outlook. Always attentive to investment calls from institutions with solid track records, we felt compelled to ask ourselves, could it be time to look at Brazil?

Brazil has not been worth looking at since April 2008 when, with immaculate timing, S&P upgraded the country to investment grade. Patiently biding their time through a seven-fold increase in the Ibovespa over the previous six years, the analysts over at S&P made their call within 6% and a few weeks of the all-time high for Brazilian equities. Since that fateful last day in April, the Ibovespa has fallen 32% in local currency terms and a whopping 67% in US Dollar terms.

So, could S&P be making another breath-taking call? Could Brazilian equities, today depressed and unloved, represent an attractive investment opportunity?

Well, the first thing we should note is that the Ibovespa is a notoriously lousy index and over the period in question, its performance mostly represented the collapse of two state-owned, commodity-dependent giants (Vale in iron-ore and Petrobras in oil) and a clutch of so-so steel companies. Over the period, Vale managed to lose 70% of its value, Petrobras 82% and Usiminas, a bell-weather steel company, 86%, all in local currency terms. In fact, out of the 147 Brazilian stocks Bloomberg reckons had listings over the period, 62% actually rose, as high quality, non-commodity private sector companies performed pretty well while the index was in free-fall.

So, it is not that the Brazilian equity market has dropped to bargain basement levels so much as that a couple of hopeless, government-controlled entities, a few uncompetitive steel stocks and the currency have plummeted while everything else has been tooling along. And the valuations of reasonably successful Brazilian companies reflect this reality, as anything a foreign investor might want to buy in Brazil (like Cielo, credit card processing; Totus, software; Ultrapar, gasoline stations; Ambev, beer and CCR, toll roads) trades on a PE multiple of between 16-21x. While these valuations are hardly excessive, they are definitely not bargain basement.

However, surely the drop in the currency has the potential to blossom into a significant positive for Brazil? After all, the Real has fallen a hefty 60% since its peak in July 2011 and is back to levels last seen in the pre-commodity boom year of 2002. The issue, of course, is that oil, mining and agriculture account for 62% of Brazil’s exports and the prices of these things are all down big time too. Brazil’s top five exports, iron ore, sugar, oil, soy and coffee have witnessed price declines of 62%, 67%, 61%, 50% and 25% respectively since 2011. Unfortunately, Brazil’s terms of trade have moved decisively against the country over the last four years and arguably all the currency drop has been able to achieve is a moderate amelioration of the move’s worst effects. There has been a swing into positive territory for Brazil’s trade balance since March 2015, but only a small one.

(We are going to ignore, possibly until another time, the potential attractions of Vale, where consensus opinion claims another 10 years of bear market in iron ore is still in front of us due to big, fat mines coming on stream in politically stable countries. We also plan to sidestep Petrobras, iconic, reserve-rich symbol of Brazil’s growth potential turned corrupt, incompetent pawn of raving socialist politicians).

Undoubtedly, Brazil is in a tight corner. It has to pay so much interest on debt from abroad that the current account deficit is 4.3% of GDP even with a trade surplus. The government spends so much on payroll and social security that it can only afford to spend 1% of GDP on public investment and the World Economic Forum ranks the quality of the country’s infrastructure 120 out of 144 countries. The government budget deficit is expected to approach 9% of GDP this year and the inflation rate has been in relentless acceleration, topping 9% in July. GDP growth has been negative over the last five quarters and the country has lost 900,000 jobs in the twelve months ending July. Dilma herself (the country’s president) is down to impeachment-worthy single digit favourability ratings.

Sometimes though, dire economic circumstances can be hugely positive for investors. Sometimes, countries in tight corners run out of inappropriate options and are forced to do the right thing. Could Brazil’s government, after so many years of populist interventionism be compelled to implement some free market orthodoxy?

There have been a few signs of movement in this hopeful direction. Dilma has said she wants to cut down the number of ministries from 39 to 10. She has also announced a new $64bn private sector-financed infrastructure investment plan.

Dilma tried selling investment concessions once before, in 2012, but her left-wing instincts held down the allowable rates of return so only 20% of the money showed up and then only for the airports. No-one wanted the railroads or the ports – projects that might actually help agriculture and industry. This time, although details remain vague, officials promise the terms will be more attractive – specifically, the caps on investment returns are thought to have been removed. In an encouraging speech, Barbosa, Dilma’s Planning and Budget Minister, even went to far as to say that “The increase in investments in the Brazilian economy must be done by the private sector”. Although, it must be remembered that the Brazilian government has run out of money so that really does only leave the private sector. Sadly, two-thirds of the $64bn will not be auctioned off until 2019 and some projects are re-hashed versions of projects that failed in 20123, but still.

Continuing with the theme of free market orthodoxy, the government also announced a “sliding scale” to limit access to full pensions for a few years in an attempt to address Brazil’s ruinously generous pensions. This is nice but not nearly enough. Payroll taxes equal 35% of gross pay in Brazil. Without meaningful reform, payroll taxes will equal 80% of gross pay by 2050. The government spends the same in pensions on 1 million public sector workers as it does on 27 million private sector workers. Even government spokesmen admit this plan is a “temporary solution”. The government needs to sit down with the labour unions, pensioners and employers and hammer out a lasting reform.

To us, these latest announcements are hardly worth analysis.

Brazil needs a wholesale privatization programme, starting with Petrobras and ending with every last port and lowly toll-road. It needs drastic cuts to public sector pay, employment and pensions and reform of social security to make the system solvent and bring down payroll taxes to no more than 10% of payroll. It needs the government to get out of the subsidized credit business. The labour market regulations enshrined in the constitution (30 days of vacation, employer-funded transport and meals, the 13^th salary) need to be phased out and the whole labour market deregulated. If Brazil’s government announced measures like these, Brazilians would have to duck to avoid being hit by the wave of foreign investment that would pour into the country.

So, although we are attracted by the contrarian nature of Brazil today as an investment and respect S&P’s gutsy call, we cannot construct the sort of positive case the Ibovespa would need for anything more sustainable than a dead cat bounce. Brazilian stocks, at least the ones anyone would want to buy, are not cheap; the currency is just compensating for lower commodity prices and there are no prospects for real economic reform.

Amazon is the non-profitable behemoth of the ecommerce world. Loathed by many for putting indy book stores out of business; lauded by at least as many for transforming the time-consuming chore of shopping into a quick, easy, cheap and less risky endeavour, offering the restoration of hours of free time to anyone with an internet connection.

Amazon started out, of course, selling books but sometime in the early ‘00’s began selling everything. Today Amazon sells 356 million products. Walmart.com sells 4.2 million. A typical Walmart store sells 200,000. In the latest quarter, Amazon, which began operations in 1995, reported trailing twelve month revenues of $95bn, roughly half the revenues of Walmart, which opened its first store in 1962.

So, Amazon is big and it is useful. But it is not profitable. And because of this, some fear it is an elaborate Ponzi scheme. Could this be true? How long can Amazon continue in business while failing to turn a profit? And if Amazon does not report profits, how can it possibly justify a $235bn market capitalization?

Amazon seems to have studiously avoided reporting net profits since it opened its metaphoric doors 20 years ago. Some investors maintain that Amazon operates at break-even on purpose. We have some sympathy with this view.

First, it’s a business strategy: Amazon has its own chart explaining its strategy which starts with customer experience and ends with lower prices. The implication is clear. Whenever it can (i.e. whenever it has just earned a few dollars of profit) the company will lower prices to enhance customer experience and drive growth.

Second, it’s tax-effective: No reported net income does lower a corporation’s tax bill. Reinvestment of profits is a tax-free alternative.

Third, it’s a competitive weapon: Amazon clearly wants to be a very big fish in the retail sea and operating at break-even makes it hard for competitors, some of whom have more traditional shareholders who prefer profits and dividends over endless investing for long term growth.

However, we also note that between 2000 and 2010, Amazon’s net income line swung from a loss of almost $1.5bn to a profit of $1.1bn. The profit reported in 2010 was not enormous on a percentage of sales basis (3.3%) but still, the upward trend was quite well-established. Then in 2011, this trend was interrupted by an explosion in operating expenses which rose almost five-fold from 18.2% of sales in 2010 to 30.3% of sales (last twelve months), easily overshadowing the increase in gross margin which took place at the same time. Coincident with this explosion in operating expenses was another explosion in capital spending which also soared five-fold from $1bn in 2010 to $4.8bn in 2014.

To us, these numbers are not really consistent with the theory that Amazon has just been plodding along, deliberately breaking even for strategic, tax and competitive reasons. These numbers suggest Amazon was plodding along, heading towards higher profitability and then changed its mind.

One thing Amazon clearly changed its mind about was the pace at which it would grow its fulfillment platform. From January 2010 to December 2014, fulfillment square footage increased from 17 million square feet to 102 million, an almost 6-fold increase in five years. This dwarfs the historical growth rate – a comparatively pedestrian 25% p.a. Not surprisingly, fulfillment costs as a percentage of sales soared over the same period, rising from 9% to 15% of product sales. But now we can all get our stuff next day.

Another thing Amazon changed its mind about was cloud computing. Around 2009, Amazon launched Amazon Web Services (AWS) to provide “storage, compute, database, analytics and applications for any type of business.” Now, the cloud computing business requires prodigious amounts of capital to be spent on technology infrastructure (servers) and so it should not come as a shock that Amazon has probably spent close to $7bn on servers for AWS over the last four years. And, because these purchases are financed with capital leases, this spending is over and above the explosion in regular capital spending we talked about in the paragraphs above. In 2014, Amazon’s total investments of $9.8bn were seven times larger than its total investments in 2010. Few businesses could withstand such a large increase in spending without adverse consequences, so it is totally understandable that Amazon’s nascent profitability wilted under the pressure.

Amazon has always encouraged analysts and investors to measure the profitability of its business on a cash-flow basis. Specifically, Amazon states in its 10K that its “financial focus is on long term, sustainable growth in free cash-flow per share.” While, technically, free cash-flow per share has grown at 7.5% p.a. since 2009 (and 22% p.a. since 2011), once we add back in spending on capital leases, free cash-flow has not grown at all. In fact it has moved from a surplus of $2.8bn in 2009 to a deficit of $2.1bn in 2014.

A break-even P&L can be overlooked if there is enough operating cash-flow to cover investment spending. But negative free cash-flow moves the burden of financing growth on to the balance sheet which is definitely not an infinite source of capital.

So, upon close inspection, Amazon’s recent results are neither sustainable nor free cash-flow positive; the two things Amazon’s management promised they would be. And, surely, if Amazon cannot even show a positive number (let alone growth thereof) for the metric it has emphasized it should be measured against for all these years, the company just has to be a Ponzi scheme. Right?

Well, we can think of a couple of mitigating arguments immediately. No doubt there are others. First, capital spending, at the end of the day, is discretionary – even in a competitive environment. The folks at Amazon are not stupid. Do they really intend to trash their balance sheet for the sake of a spending frenzy on servers for AWS and putting a fulfillment center on every corner in America?

Second, Q2 2015 numbers did show a sharp drop in the rate of growth of both sorts of capital spending. The year on year increase in spending on capital leases fell from 114% in Q4 2014 to just 17% in Q2 2015 and capital expenditure actually fell in H1 2015 year on year. Hallelujah. The result of all this restraint is that on a trailing twelve-month basis, Amazon was almost break-even on a free cash-flow basis in Q2 2015. Was the explosion in investment between 2010 and 2014 a one off? Maybe. We may find ourselves sufficiently curious about this point over the next couple of weeks to put a call into the company.

Swayed by these mitigating arguments, our supposition is that Mr. Bezos has not (yet) succumbed to hubristic clouding of the faculties and will not sacrifice his balance sheet on the altar of growth. He knows that nothing interferes with the “sustainable” part of his mission statement like a crumbling balance sheet. Our bet is that spending will become more controlled in the future and will be (mostly) financed with internally generated funds.

Amazon may not be a Ponzi scheme, but is it worth $500 a share? Amazon’s shareholders are a forgiving bunch and have been more than happy to ignore the bottom line and value the company on a price/sales basis for many years. At 2.5x Amazon is actually not that egregiously expensive. Both Dollar Tree and Home Depot are selling at 1.8x sales. And the stock looks like a bargain against Alibaba, trading at a starry-eyed 13.5x price/sales. The Consensus is of the opinion that it is fine to value Amazon on price/sales because the company could turn a profit any time it wanted to just by raising prices a smidgen. To reach a reasonable valuation, however, prices might have to go up by more than just a smidgen. A 5% increase in total revenue, ceteris paribus, would produce roughly $4bn in net profits and leave the stock on a still generous PE multiple of 58x.

No, to make the stock a buy here, investors have to hope that Amazon really never comes to be valued on profits but continues to change hands on the basis of a reasonable multiple of revenue.

One key to this continuation is the belief in “sustainable growth”. (Mr. Bezos, please see above analysis). Another key is the size of the market opportunity in front of Amazon. Ecommerce today has roughly an 8% share of US retail revenue. Amazon, with roughly 14% of the ecommerce market, has 1% of US retail sales.

Amazon is big – but could easily be a lot bigger.

Last week, the case for raising the Fed Funds rate in September was reopened. Mr. Stanley Fischer, the Fed’s number two guy, blamed the “..change in circumstances which began with the Chinese devaluation..” for the Fed’s change of heart. Mr. William Dudley, New York Fed President claimed that the case for raising rates had grown “less compelling” in the wake of market tumult.

Faithful journalists at the WSJ, casting about for some solid economic underpinnings to support this change in policy thinking, blamed “China’s economic slowdown.” But, let’s face it – China’s economy has been slowing down since 2010 and the most recent bout of deceleration began in Q3 2013. If it were China’s economic slowdown that was upsetting the monetary tightening applecart, it would have surfaced as a factor months ago. In isolation, even China’s devaluation, a modest, controlled 3% over two days surely would have been overlooked if it had not been for the accompanying market reaction.

No, it seems to be not so much economic deceleration or tweak in the forex rate as a Chinese stock market in free fall that has caught the attention of the good folk of the FOMC.

The fact that the Chinese stock market shot up like a rocket during the first half of 2015 and now appears to be merely regretting that impulsive move and correcting back to where it was, is being studiously ignored by media commentators and FOMC members alike. Equity markets, apparently, are only relevant to interest rates when in rapid descent.

The other equity market causing concern, according to Mr. Fischer, was, of course, our own. And the members of the Fed admitted this quite freely last week. Mr. James Bullard (President of the Federal Reserve Bank of St Louis) declared he ”…was willing to respect volatility in the markets.. ” Mr. Fischer himself said “If you don’t understand the market volatility…it does affect the timing of a decision you might want to make.”

So, let’s see if we have this straight. GDP growth gets revised up to a dazzling 3.7% in Q2 2015 and the Feds breeze past that weighty (at least in times gone by), all-encompassing number, and all the other numbers they have presumably been gathering, to focus on the fickle equity market. Which, of course, is going down, otherwise it would not have been noticed in the first place (see above).

Such evidence suggests to us that for Ms. Yellen’s data-driven FOMC, one particular sort of data towers in importance above all other sorts of data. And that data is the equity market. Or rather markets. Ours, China’s. Really, any large country’s equity market could qualify (we feel certain) as long as it was falling sharply enough.

This protective, almost motherly, focus on equity markets seems wrongheaded to us. For a start, equity markets are jumpy things. Like small children, they are always running ahead of themselves and getting scared out of their wits. They are creatures of emotion, very loosely tied to the economic fortunes of the companies whose stock prices they quote. Of course they are volatile. This should come as no surprise to the seasoned economists at the Federal Reserve.

To give this immature data-point, which barely deserves to be included in the discussions to determine the Fed Funds Rate, precedence above all other data-points seems to us to be, at the very least, ill-advised. To continue with our child metaphor, it would be like allowing the 2 year old to decide where the family is going to go on vacation.

More disturbing still is that making a rise in interest rates contingent upon a stable stock-market could be construed as that mother of all moral hazards, viz. propping up the market. Isn’t that what we keep telling China’s authorities they are not supposed to be doing?

Including asset price behavior – especially that of houses and equities – in the analysis that goes into determining the correct level of short term interest rates seems eminently sensible to us. Allowing wiggles in the equity market, at the drop of a hat, to override this considered analysis seems very much less so.

“Whenever you find yourself on the side of the majority, it is time to pause and reflect”.

Mark Twain

The incomparable Street.com published an informal poll sometime during yesterday’s, mid-morning dead-cat bounce (following the carnage of the day before). The results of said poll indicated that while 47% of folks were bearish of the US stock market, a solid 68% were still bullish. The incomparable Street.com seemed to imply that this was a positive signal for stock prices.

Leaving aside for the moment the fact that 47 plus 68 equal 115, may we humbly offer a less sanguine interpretation of said poll results? Viz, that if the Street.com’s pundits are shrugging off the market’s plunge, there may be more plunge to come? In the short term, at least, the relaxed presumption of a continuation of the bull market needs to be rattled out of the sort of investor who responds to  the Street.com polls.

In our view, critical to the formation of an opinion on just how much rattling needs to take place and just how much plunging is yet to come, is a proper reason explaining why we are experiencing market plunges in the first place.

In a review of the usual suspects, first up is valuation. Is the market expensive? The S&P is on 16.5x trailing earnings (down, quite abruptly, from 18.6x last week). And on 15.8x forward earnings (17.7x last week) based on modest 5.5% earnings growth over the next 12 months. Compared to long term averages, these are not extravagant PE multiples. The average trailing PE for the S&P since 1980 is 17.7x and the average forward PE is 16x. The range is 12x-30x although, to be fair, we only got to 30x once, in a fit of hysteria when normally sane citizens fell over themselves to pay something for nothing.

On a price to book basis, the market looks almost attractive. The S&P is on 2.5x price to book versus the 35 year average of 2.8x. On a price to cash-flow measure, the S&P also looks appealing. Dividend yields? The S&P is currently offering a handsome yield of 2.2%.

Moreover, it is worth remembering that the market’s long term average PE of 16 was set in a period when long bond yields averaged 5%. Today long bond yields are 2%. Also, net debt to ebitda has fallen from almost 5x to 1.9x since 2007 as corporations in the S&P 500 Index have reduced their debt by 61%. Stocks arguably deserve higher valuations today.

So, no, the market does not look expensive to us. In our view, the market was not expensive last week either and we would argue that the recent downdraft was really nothing to do with valuations, per se. And on valuation criteria alone, we are at a loss to see why the market would need to plunge further from here.

Ah, but, the problem is not valuations per se, (we can almost hear our readers cry) but valuations in conjunction with rising short term interest rates. Ah, yes.

Second up; tighter monetary policy. Ms. Yellen has telegraphed far and wide her intention to start raising short term interest rates in September. She has also made clear that her decision will be driven by the data. By that we take her to mean the economy will be showing decent growth across most important sectors and be resilient enough (in the Fed’s opinion) to withstand a normalization of the yield curve without wilting. Fans of data ourselves, we looked at the economic indicators available to mere mortals in the public domain and concluded, with all humility, that it is possible Ms. Yellen has actually missed her window of opportunity.

Industrial production growth has slumped over the last six months from 4.9% to 1.3% on July. Manufacturing and Trade sales peaked in June of last year and fell 4.6% over the subsequent seven months – the first fall of such magnitude since the last recession. Exports took a hit in Q4 2104 and Q1 2015 falling by 4.5%. Manufacturing Orders contracted every month during the second half of 2014 and into January of this year. GDP growth has moderated from c.3% to 2.3%.

No question, economic activity has run out of puff in the last six months.

What about inflation? – the usual reason any central banker decides to raise interest rates. The reported numbers at least, show no resurgence of inflation in the US at all. The CPI ex food and energy is bumbling along near its all-time low of 1.8% year on year. Average hourly private sector wage growth is back under 2% year on year after a brief bounce to 2.4% in Q1 2014. Commodity prices have been weak…

A  sudden pause in economic growth and no inflation. Maybe Ms. Yellen should reconsider? If she really is data-driven, why didn’t she raise rates a year ago, when the economic picture looked significantly rosier? If she didn’t do it then, how can she possibly want to do it now?

Only one answer comes to mind; asset prices. House prices and stock prices have been rising significantly faster than inflation. But look, just the threat of higher interest rates has already had the intended effect on the equity market.

Asset price bubbles and house prices notwithstanding, we conclude that given the softer economy and the absence of any nasty inflationary pressure, rates, whenever Ms. Yellen makes her move, will not go up by much. The market historically has been able to tell the difference between serious tightening to forestall over-heating and accelerating inflation (1989, 2000 and 2008) and not-so-serious tightening (1993) to return to a regular yield curve.

So, yes, investors have been skittish about the timing and magnitude of interest rate increases but deep down they realize that monetary conditions that are a little, itsy bit tighter than they are today will not signal their doom.

No, what they are most concerned about, in our opinion, is the very thing which may stay the Fed’s hand; the economy’s lack of puff.

Why has the US economy stalled? Everything was just fine until June 2014. In our view, the 22% revaluation of the US Dollar in eight months has a lot to answer for. The US economy has rarely suffered such a jolt to its terms of trade. (Outside of the last recession, the last time the US Dollar revalued so abruptly was in 1998 when investors were busy with other distractions).  No wonder the manufacturing sector and exports have dived while housing, a completely domestic industry, has continued to prosper.

For an even clearer picture of the divergence between the tradeable and non-tradeable sectors, compare the non-manufacturing purchasing managers survey, whose index has been on a steadily upward trend since 2011 and hit a new high in July with the reversal in S&P 500 Index revenue growth from +5% to -4% in the past three quarters.

But while exports are only 14% of GDP and the services sector in the US is larger than the manufacturing sector, foreign sales account for almost half of revenue for the companies in the S&P 500 Index. The rise in the dollar has wreaked havoc with corporate earnings growth over the last three quarters, and these earnings are what investors care about most of all. Earnings for the S&P 500 peaked in Q3 2014 and are down 3% in three quarters after 24 straight quarters of growth. Of course investors are spooked.

But the Dollar effect is, to a great extent, temporary. It will be anniversaried. Prices will be adjusted. US industry remains competitive. The US current account deficit is just 2.3% of GDP down from 6% in 2006. And the domestic sectors of the economy continue to grow. If we are correct, and the rise in the Dollar is the most important reason for the recent weakness in manufacturing, industrial production, exports, sales and earnings growth and, most visibly, equity prices, the stock market will not have to do too much more plunging.

Gosh, maybe the Street.com’s pundits were right after all.