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Investing Down Under

  • Australia has a stable and transparent economy, is rich in natural resources and the AUD currently looks cheap.
  • The Australian stock index consists of mostly financials but all have excellent ratings.
  • Only 0.09% of the S&P 500 revenues are generated in Australia therefore Australia provides additional international diversification.


Australia is a country with a population of approximately 23.5 million people, highly developed with a GDP of $47,186 per capita, low unemployment rate of 6.1% and low government debt at 35% of GDP (US 125.3% of GDP). The long term interest rate is at 1.75% and the country is ranked in 13th place on the global doing business list. The Australian economy grew 3% in 2015 and it is dominated by the service sector representing 68%, followed by the mining sector that represents 7% of the economy. The above seems stable and therefore this article is going to provide an analysis about the potential risks and rewards of investing in Australia.

The Australian Stock Market

The most commonly used index for the Australian stock market is the S&P ASX 200. Even if Australia is famous for its mining industry, the biggest weighting in its stock index are financials with 47.7%, followed, of course, by materials at 13.8%.

1 figure asx 200 sector breakdown
Figure 1: ASX 200 Sector breakdown. Source: ASX 200 List.

The financials have the biggest weight in the index as the four biggest companies by market capitalization are banks. All of them have an excellent credit rating which should imply long term stability of the financial system and limit investing risks.

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Figure 2: Australian biggest banks credit ratings. Source: Relbanks.

The above credit ratings make Australian banks among the best in the world and they seem even better when compared to US peers.

3 US banks credit ratings
Figure 3: US bank ratings. Source: Financial Times.

In relation to valuation, the Australian stock market is not cheap with an average PE ratio of 15.7, but it is cheaper than the S&P 500 with 23.88. The dividend yield is also on the Australian side with an average 4.7% yield versus the S&P 500’s 2.12%.

The Australian stock market shows less historical volatility than the S&P 500.

4 asx 200
Figure 4: ASX 200 index from 1990 compared with S&P 500. Source: .

Australia seems like a stable country to invest in but before directly investing the currency issue has to be assessed.

Australian Currency

With international investing, currencies play a big, if not main role. Economic growth and dividends might not mean much to an investor if currency losses eat up the gains. The main influences on the Australian dollar (AUD) are the interest rate, imports, exports and the stability of the economy.

On May 3, the Reserve Bank of Australia decided to lower interest rates to a record low of 1.75%. Historically the average has been 4.92%. A low interest rate should imply a weak currency as investors look elsewhere for higher yields. An even more important factor for the AUD are commodity prices as the mining industry that comprises 7.4% of GDP is exporting most of its goods. Australia mainly exports iron ore (25% of exports), coal (15%), oil (10.4%) and copper (2.1%). If commodity prices are high then more AUDs are needed to pay mining expenses and therefore the AUD is stronger. In relation to GDP growth and economic stability, the International monetary fund forecasts the Australian economy to grow at a stable rate of around 2.8% for the next 5 years.

5 aud vs usd
Figure 5: AUD per 1 USD. Source: XE.

The above mentioned influences result in a very volatile currency that is very strong when commodity prices are high and weakens as commodity prices drop. The AUD has depreciated against the US dollar by more than 30% in relation to the USD in the last 3 years. A recovery in commodity prices could give a boost to the Australian economy, increasing interest rates and increasing the value of the currency.


International diversification is a very controversial topic as both practitioners and academics constantly research and discuss it. The S&P 500 already generates more than 50% of its revenue overseas so further diversification might be questionable, but Australia stands out as only 0.09% of the S&P 500 revenues are generated Down Under.

Apart from uncorrelated revenues, Australia also offers political and legal stability, economic transparency and a relatively high dividend yield and low PE ratio. The currency will for sure be volatile towards the USD but that volatility might increase the positive returns as the AUD has only been falling in the last few years alongside the fall in commodities.



The Odds for a US Recession

  • The current is the fourth-longest US economic expansion period with 84 months of growth.
  • Investment spending has been declining for the last 4 quarters.
  • Recession forecasts indicate increased chances in the medium term.


The scariest word for any investor is the word recession. A recession arises when there is negative economic growth for two consecutive quarters. No economic growth makes it difficult for businesses to grow as people tend to spend less and save until better times come around. This creates a spiral as less spending forces companies to lay off employees and further cuts investments. If prolonged economic hardships persist, governments intervene with quantitative easing or with other projects to get the economy going again. A recession has an immediate negative impact on financial markets as investors become more risk averse and seek security above all.

1 figure gdp declines and stock market
Figure 1: S&P 500 and recession signals in the last 10 years. Source: Yahoo Finance and author.

Even a simple quarterly GDP decline ignites fear in the markets and influences a decline. In the long term there is nothing to worry about as recessions are normal parts of economic cycles, but some decisions related to individual investing goals can be made based on the probability of a future US recession in order to minimize risks.

2 figure economic cycle
Figure 2: Economic cycle. Source: mrshearingeconomics.

Current Situation

The current situation is odd as the quantitative easing that is supposed to turn around an economy is still going on with low interest rates. Usually governments stimulate the economy until growth is reached, but since the financial crisis governments have kept stimulating economies in order to prevent any recession signs. This artificial environment creates fears that if a recession should occur governments would not have any fire power to help the economy as interest rates are already at historic lows and liquidity is not an issue. This limited government potential action is what scares investors as there would not be any short term backup in case of a recession.

The last US recession ended in June 2009 which puts the current economic growth period at 83 months or almost 7 years. Based on data from 1949 from the National Bureau of Economic Research (NBER), average US economic expansions last for 58.4 months and contractions for 11.1 months. As the current expansion cycle is already two years over the average, economic laws will eventually kick in.

3 figure 4thlongest expansion
Figure 3: Current US expansion is the fourth-longest to date. Source: Bloomberg.

Modest growth or stagnation is forecasted for the next few years as employment is reaching its full potential and any unplanned macroeconomic shocks might influence a recession. The 0.5% economic growth in Q1 2016 certainly has not helped. Investment spending is a forecasting indicator as it shows when full potential spending has been reached due to satisfied demand. As targeted levels of capacity are reached, companies begin to limit investments and return more capital to shareholders. Gross private domestic business investments have been declining for 4 quarters and the below chart shows how this is a good recession indicator.

4 figure domestic investments
Figure 4: Gross domestic private investment: Domestic business. Source: Federal Reserve Bank Economic Research (FRED).

In two previous occasions, as investments slowed down, recessions appeared. Morgan Stanley gives a 30% chance to a recession occurring in the next two years and while Deutsche Bank gives a 50% chance in the next four years. Jim Rogers is more pessimistic and forecasts a certain US recession in the next year, Bank of America gives a 50% chance in the next year while JP Morgan is almost certain with a 92% chance of a recession occurring in the next four years.

5 figure recession probability
Figure 5: Probability of recession from a multivariate regression model. Source: JP Morgan.

Meaning for Investors

Except for the fact that a recession has a negative impact on financial markets, there are some other factors that have never been there historically and distort forecasts. The first interesting indicator is the comparison of the FED’s balance sheet and the S&P 500.

6 figure fed balance sheet and S&P 500
Figure 6: Correlation between FED’s balance sheet and S&P 500. Source: FRED.

The correlation is 90% in the last 7 years and shows how the increased liquidity supplied by the FED had a positive effect on financial markets as low interest rates increased corporate profits. The conclusion here is that if signs of a recession arise and the FED is limited in using easing methods like lower interest rates, the stock market decline is probably going to be fast, impactful and could easily create panic as the case was in August 2015 and January 2016.

According to the above, a recession is inevitable as the natural economic forces are bound to come to life sooner or later. It would be better to be later than sooner, but such events are impossible to time due to the many factors influencing and the FED’s ability to artificially alter the natural course of economic cycles. Unfortunately, the more artificial a situation is the more painful will be the return to long term balance.

Conclusion and Investing Strategies

The above economic situation has to be put into a risk reward perspective. A 50% chance of a recession means that a stock portfolio has a 50% chance of falling by 25% or more in a short time as markets usually anticipate recessions. With the current S&P 500 dividend yield of 2.13%, investors might analyze their risk and reward position.

Also a strategy has to be related to individual investing goals. Investing a large lump sum in the market at this point should be very risky while slowly taking the accumulated unrealized profits of the 7-year bull market might not be crazy. The market already gave investors two warnings with sharp declines in August 2015 and January 2016 followed by recoveries due to the FED’s action in August and commodities recovering in January. On the other hand, starting investors with small monthly investment amounts should be in the best position as a recession will enable them to buy investments at cheaper prices and therefore give better opportunities to their long term portfolio growth. For senior investors, a more cash oriented portfolio might be better as the risks outweigh the returns in the short term.



Is There Equilibrium in Oil?

  • Production costs are below current prices and reserves are constantly growing.
  • OPEC’s rosy forecast of $70 a barrel in 2020 is based on a model excluding any disruptions from electric engines or renewable technology developments.
  • Demand in developed countries is declining and the trend might spill over to developing countries.


Oil prices above $100 a barrel seem impossible but they were a common thing just two years ago. 2014 was the worst year for oil as it tumbled more than 50% from above $100 to below $50 a barrel. In January 2016, oil reached lows not seen since 2001 and 9/11 with prices below $30. The current price of oil quickly rebounded from those lows and is currently around $45 a barrel.

1 figure oil prices
Figure 1: Oil prices 10-year chart. Source: Nasdaq.

As oil is a commodity, its price is formed by the levels of supply and demand for it and future expectations. This article is going to analyze the oil market and look for an equilibrium price in order to make oil related investments easier to assess.

Oil Supply, Demand and Stock Levels

The first thing to look at is the US stocks of crude oil.

2 figure stock piles
Figure 2: Weekly ending stocks of crude oil and petroleum products. Source: U.S. Energy Information Administration.

The current stocks are at an historically high level and the recent uptrend is easily correlated with the slump in oil prices. A look at supply and demand is necessary to see if the stock levels are just going to grow higher or there is a possibility for further increases in oil prices.

Oil Supply and Demand

A look at oil supply has to be global as the costs of shipping oil around the globe are also at historic lows. World oil supply has been surging as new technologies like shale oil extraction became a profitable investment with high oil prices.

3 figure world oil supply
Figure 3: World oil supply. Source: International Energy Agency.

Global oil supply increased by more by 5.5% from 2013 and only started to decrease in Q1 2016 as high cost producers are slowly forced out of the market. But, demand is still below supply as producers are hoping for a rebound in oil prices and therefore keep production alive.

4 figure world oil demand
Figure 4: World oil demand. Source: International Energy Agency.

The daily average production oversupply is consistently around 0.5 and 1 million barrels. For a sustainable rebound in oil prices that daily oversupply has to vanish.

5 figure oil demand supply
Figure 5: Oil supply and demand. Source: Yardeni Research.

A look at producing costs, resources and potential output will give us an answer to the long term oil outlook.

Production Costs and Potential Output

The average production costs per country show that production costs are far below the current oil price except for the UK.

6 figure oil production costs
Figure 6: Oil production costs by country. Source: The Wall Street Journal.

Usually production costs are the ones that set a bottom to commodity prices and therefore it seems from the above figure that lower prices are more probable than higher prices.

Reserves and Output

Currently the global proved oil reserves amount to 1,700.1 billion barrels, which is sufficient to meet 52.5 years of global production. Even with increased oil production, oil reserves have increased by 24% over the past decade. Oil reserves to production ratios show that there is plenty of new potential output if prices increase which can easily bring prices down again.

7 reserves to production
Figure 7: Reserves to production ratios. Source: BP.

High reserves and low production costs are not the only trouble for oil producers, maybe the most important one is that as the world develops less oil is needed due to higher environmental standards, improved energy efficiency and increased support for renewable energy. The decrease in demand from OECD countries shows how important and dangerous for oil this is and can be.

8 figure oil OECD demand
Figure 8: Demand for oil in OECD and developed countries. Source: Yardeni Research.

Oil demand in developed countries peaked in 2006 and is not growing any more. With China slowing down and fuel efficient and electric technologies quickly spilling over globally, the outlook for oil is not bright. The OPEC (Organization of the Petroleum Exporting Countries) forecasts oil prices of $70 a barrel in 2020, $123 by 2030 and $160 by 2040 including inflation. These forecasts have to be taken with a grain of salt as oil producers tend to be overoptimistic creating forecasts based on models that use current data and trends while excluding the influence of disrupting technologies and cost saving oil exploitation methods and keeping reserve levels fixed. Based on current trends OPEC forecasts oil demand growth of only 0.7% per year up to 2040. Similar forecasts were made in 2009 when Goldman Sachs forecasted oil prices of $200 a barrel based on the continuation of previous trends. Therefore, the OPEC scenario should be used as the best case long term scenario.


Oil reminds of phone lines: once essential and now almost obsolete. Investors always have to be aware of secular trends and assess their risks properly. Oil prices and oil related investments are going to be volatile for sure, but the low production costs, high reserves and new technologies do not create a positive outlook. As supply can easily cover demand, no spikes in demand are forecasted as the world is turning to cleaner and renewable energy sources. Oil exploitation is in a declining trend and stocks should be considered only as cash cows. High and expensive exploration projects like Royal Dutch Shell’s Arctic explorations should be avoided as only low cost producers with high reserves should be considered. As the low cost producers are mostly state-owned, finding the best investment necessitates proper understanding of the oil sector and due diligence. As a general investment, oil currently does not show any long term positive catalysts. Short term spikes are always possible.



Hedge Funds as Investment Diversification

  • Hedge funds have performed miserably in the last bull market but things might turn.
  • Fees are the deal killer as 2% of assets under management and 20% of profits eats up all the returns.


There is currently a negative sentiment towards hedge funds as they mostly underperformed the market in the last 6 years. This article is going to elaborate on how hedge funds work and relate that to the current circumstances in order to assess investment possibilities.

What is a Hedge Fund?

A hedge fund is an alternative investment strategy that uses tools like derivatives and leverage. The goal is to achieve alpha returns (beat the market) while having a low correlation with the common stocks and bond markets. Therefore, hedge funds are considered good diversification. The name derives from the word “hedging” which is the practice of maximizing returns with reduced risk.

The catch with hedge funds lies in the unusually high fees, usually 2 and 20, which means 2% of assets under management and 20% of profits. In 2008, Warren Buffett made a bet with hedge fund Protege Partners, LLC that his simple S&P 500 fund would beat a hedge fund with a team of managers at the helm in a 10-year period if not for other than only the hedge funds fees (0.16% S&P 500 fund vs 2 and 20 hedge fund). After the initial 2008 scare Buffett can already celebrate his win and make the hedge fund donate $1 million to a charity of his choice as the S&P 500 fund is up 65.7% while the hedge fund is up only 21.9%.

1 figure buffett bet
Figure 1: Protégé partners wager result at end of 2015. Source: Yahoo Finance.

Hedge Funds Historical Performance

But, in the long term it does not look that bad for hedge funds. From January 1990 to February 2016 hedge funds managed to outperform the S&P 500 with less volatility (prior of fees).

2 figure bloomberg
Figure 2. Hedge funds, S&P 500 and bonds performance and volatility. Source: Bloomberg.

The above shows that hedge funds have a point but the fees remain the question as they eat up investors’ returns. The main contribution to the above returns was made in the nineties and since then hedge funds have underperformed as the market strongly marched ahead.

3 figure hedge fund perfrormance by strategy
Figure 3: Hedge fund performance by strategy. Source: Bloomberg.

There are several potential reasons for the poor performance. One is that there are too many hedge funds and not enough market inefficiencies to sustain a $2.9 trillion industry. Another reason is the nature of hedge funds: they are not supposed to be up when stock markets are up and seeing that the stock markets were mostly up, it is very difficult to outperform. Poor performance results in investors redeeming funds and further igniting the decline by forced sales of assets. But a bear market should give hedge funds a run for their money and give excellent diversification to investors that think the market is currently overvalued.

Going by the saying be greedy when others are fearful and be fearful when others are greedy, it should be a good time to be exposed to some hedging diversification. Considering that many investors have lost their patience, like the life insurer MetLife who is seeking to redeem $1.2 billion of its hedge fund investments due to poor performance, or American International Group (AIG) that is redeeming $4.1 billion due to three straight unprofitable quarters, it might be the correct time to invest in hedged investments.

Hedging Investment Opportunities

Of course, the first option is to directly contact a hedge fund but you have to be a sophisticated investor, and thus have more than $200,000 in annual income and a net worth higher than $1,000,000 excluding your home. There are also other possibilities that can give similar results with lower fees. One strategy is investing in alternative mutual funds that use a long/short strategy. There are also ETFs that try to replicate the hedge fund index performance. ETFs can only try to replicate because hedge funds do not always disclose their trading activities unlike the above mutual funds. Options are the ASG Global Alternatives fund, the Credit Suisse Multialternative Strategy Fund or the IQ Hedge Multi-Strategy Tracker ETF.

The third option is copycat investing by following the 13F forms filed to the SEC by hedge funds and following their strategy, albeit at a later point in time. An article about hedge funds would not be a good one without mentioning the notorious Carl Icahn, owner of Icahn Enterprises Limited Partnership (NASDAQ: IEP) of which units can be purchased on the open market by anyone. It is a good hedging opportunity as, according to the last report, the IEP had a net short position of 149% at the end of the last quarter. But, a warning must be issued here as the net asset value of IEP’s unit is around $38 while the unit price on the market is $57.

4 figure IEP perfromance
Figure 4: IEP unit performance in the last 10 years. Source: Yahoo Finance.


The easiest investing strategy would just be to follow Buffett’s advice and buy the S&P 500 and enjoy long term, steady returns correlated to the US and global economies. But, investors then must also be able to weather periods of increased volatility and bear markets. For the ones that would like more diversification and an opportunity to lower volatility and maybe even increase returns, hedge funds or hedge fund alternatives should be a good option.



Is It a Good Idea to Invest in Lithium?

  • Tesla announced building 500,000 cars in 2018 and purchasing the complete current global lithium supply per year.
  • Lithium is not scarce and could easily get oversupplied even with demand growing.
  • Other technologies, like vanadium batteries, will always present a threat to lithium.


On May 5, Tesla’s (NASDAQ: TSLA) Chairman and CEO Elon Musk announced that TSLA intends to produce half a million cars in 2018. Apart from the craze currently surrounding TSLA, the trend towards electric vehicles is undeniable. An option that does not imply direct investments into electric cars manufacturing companies is an investment in lithium related investments as lithium is the most important material for battery production. This article is going to elaborate further on the investing possibilities, risks and rewards of the lithium option.


Lithium is a soft, silver-white metal with lots of industrial applications including heat-resistant glass and ceramics, lithium grease lubricants, flux additives for iron, steel and aluminum production and most importantly, lithium batteries and lithium-ion batteries. The demand for lithium batteries has fueled an immense increase in lithium prices in the last 12 months.

figure 1 lithium prices
Figure 1: Lithium related products price movements in the last 360 days – China. Source: Asian Metal.

Surprisingly, increased lithium prices had an opposite effect on the Lithium ETF. As more and more projects are announced for lithium mining, existing producers face lots of competition and the above spike is considered temporary.

figure 2 lithium etf
Figure 2: Lithium ETF. Source: Yahoo Finance.

The Global X Lithium ETF (NYSEArca: LIT) has performed terribly in the last 5 years. It fell from a value of above $46 in 2011 to the current $22.63. The ETF consists of the world’s biggest Lithium miners and lithium related companies like TSLA.

figure 3 lithium holdings
Figure 3: Lithium ETF top 10 holdings. Source: Global X.

The problem is that all of the top holdings that are lithium miners have seen their stock price plummet since 2011 as none of those companies is a pure lithium miner. FMC Corporation gets 70% of revenue from the agrochemical market and its primary market is Brazil, while SQM—which has one third of the world’s lithium reserves—receives only 11% of its revenue from Lithium. Therefore, even if the ETF is called the Global X Lithium it is not a pure lithium mining play. Unfortunately, such an investment does not exist, except for small lithium focused miners. Also, lithium is not traded on an exchange like it is the case with other commodities like gold or copper. Therefore, finding a specific lithium investment is a challenge in itself.

A lithium focused small cap investing strategy requires high specialization and lot of due diligence. Never forget the saying that a miner is usually a liar standing next to a hole in the ground.

Lithium Potential Supply

The main reason behind the weak lithium and lithium related stocks’ weak long term performance is that lithium is not a scarce metal. Even if Goldman Sachs is estimating lithium demand to triple by 2025 to 570,000 tons, apart from short term occurrences, there should not be a supply gap for lithium because it is a highly available metal and higher demand would only allow large mining projects to become feasible and lower the price. An example is Lithium X, a small lithium miner that has a concession in Clayton Valley, Nevada, with resources of 2.8 million tons, five times the 2025 estimated demand.

figure 4 lithium valley nevada
Figure 4: Clayton Valley Nevada. Source: Lithium X.

The map clearly shows how other miners are also researching the area and will probably add to the supply in the longer term.

Another example is the Chilean company SQM (NYSE: SQM) that has produced only 38,700 metric tons of lithium carbonate in 2015 even if their capacity at this moment is 48,000 metric tons.

figure 5 sqm potential and output
Figure 5: SQM’s lithium production. Source: SQM.

Global miner BHP Billition’s CEO Andrew Mackenzie said that the lithium market is pretty small and it is unlikely that BHP will tap into it.

Risks Related to Lithium

Apart from the potential and quickly reachable oversupply, there are other risks related to lithium. As technology quickly evolves, it would not be surprising to see lithium replaced by other materials in batteries. Vanadium batteries are one example: the current advantages of vanadium are that it can be recharged more than 200,000 times while lithium batteries only about 7,000 times. On the other hand, vanadium batteries take much more space but there is always the risk that a new finding or technology might be around the corner and remove lithium from the throne.


Lithium fulfills only partly the criteria necessary for a low-risk / high-reward commodity investment. Demand is certain to increase but supply can also increase very quickly. There is no direct lithium investment except for small miners and those are always carrying high amounts of risk. The big global lithium producers have only part of their revenue deriving from lithium and have plenty of untapped mining potential in the case lithium demand increases.

Unrelated to the lithium issue but a good general example for investing in ETFs is the Lithium ETF mentioned above. As it consists of miners that receive only part of their revenue from lithium mining and companies that only use lithium, it shows how investors should do proper due diligence before investing in any ETF as the name might be misleading as it is the case for the Global X Lithium ETF.



How the Jobs Report Affects Stocks

  • The April jobs report shows two sides: slower hiring and increased working times and wages.
  • The long term outlook is pessimistic due to the constant decline in the labor participation rate.


On May 6, the Bureau of Labor and Statistics (BLS) released its monthly employment situation summary.

The report is released on the first Friday of the month for the previous month. It consists of two parts: one presents non-farm payrolls, hours worked and hourly earnings, and the other is created by surveying more than 60,000 households in order to extract the unemployment rate.

It is an economic indicator that investors and analysts anxiously look at as it is considered one of the best indicators in predicting business cycles. A rule of thumb is that an increase of 150,000 jobs indicates economic growth while any number lower than that indicates a weak job market and rough times for the economy.

Current Report and Long Term Trends

For April 2016, the jobs report showed slowed hiring and a slight increase in pay. Slower hiring could refrain the FED from raising interest rates. The non-farm payrolls rose by 160,000 and unemployment remained stable at 5%. This still does not mean much as those numbers are known to be volatile, but it is good to keep an eye on long term trends.

figure 2 us payrolls
Figure 1: US non-farm payrolls from 2006. Source: Trading Economics.

The interesting part of the above figure is the 2006-2008 period where the first periods of no payroll growth had already happened in 2006 and only later resulted in the 2008-2009 recession. Fortunately, the current situation is still far from the 2006 declines. FED Chairwoman Yellen targets 100,000 monthly job additions as a healthy measure for a stable and slowly growing economy with full employment.

Something to worry about in the long term is the US labor participation rate. Pre-recession levels were at 66% while they are currently a 62.8%. The long term decrease of 320 basis points lowers the productivity of the US economy and makes the low unemployment rate of 5% questionable as 3.2% of the population decided not to return to the job market. The main factor influencing such a state is an aging population and the Congressional Budget Office (CBO) projects the labor participation rate to fall to 60% in 2025.

figure 2 participation rate expectations
Figure 2: US labor participation rate outlook. Source: CBO.


A not so inspiring example of a declining labor participation rate is Japan. Its labor participation rate has been steadily falling since the nineties and resulted in prolonged economic stagnation.

figure 3 japan participation rate
Figure 3: Japan labor participation rate. Source: Trading Economics.


Fewer people working means less productivity and less productivity takes a big chuck off of economic growth. The above negatively influences the stock market in the long term.

figure 4 japan nikkei index
Figure 4: Japanese Nikkei index. Source: Yahoo Finance.


The Japanese stock index Nikkei is currently at the same point where it was in 1986.

Current Market Repercussions

In the short term, the constant publication of new economic indicators makes it difficult to assess the impact of the monthly jobs data on financial markets. The disappointment of the last job report that missed the consensus forecast of 200,000 by 40,000 did at first influence a decline in the markets but nevertheless the markets finished on a higher note as investors expect the FED not to raise interest rates due to the weaker job market.

figure 5 S&P 500 trading on jobs day
Figure 5: S&P 500 index on day of jobs data publication. Source: Yahoo Finance.


With Yellen targeting a 100,000 monthly payroll increase, the 160,000 for April does not look bad, but combined with the Q1 2016 GDP growth of only 0.5% it might indicate further procrastination in interest rate increases.

Hours Worked and Earnings

As companies are always reluctant to hire new employees, the hours worked can indicate where the economy is going. In April, the average workweek increased by 0.1 hour to 34.5 hours which means that companies are asking employees to work a little bit longer. Hourly earnings also increased by 8 cents to $25.53 bringing the year-over-year increase to 2.5%. Both increases indicate that there is more work and that the economy is doing fine. Also, these increases might push the FED to increase interest rates as the economy is reaching full employment and a 2.5% increase in wages is a good sign for the 2% target inflation.


This reports indicates one certainty: the US economy is not in any kind of stellar growth mode and such a scenario should not be expected anytime soon. The mixed results do not indicate a specific short term trend and thus imply stability, but stability is never the case in an economic environment. The long term outlook indicates slow growth as the quantitative easing and low interest rates keep the economy stable. Investors should be aware that there are increased risks attached to investing in the US economy, hopefully and probably they will not materialize but it is good to keep an eye on them.



Small Caps: Time to Invest?

  • Small caps have lagged the S&P 500 in the last two years, but historically outperform it.
  • Stock pickers could find a gem in the small cap world but risks are also big.
  • Small caps are more related to the US economy than large caps.

What Are Small Caps?

Small caps are stocks with a relatively small market capitalization, usually between $300 million and $2 billion. One of the multitude of reasons behind investing in small caps is their growth potential, as it is generally considered that smaller companies have more growth opportunities due to untapped markets. Another reason for investing in small caps is the fact that big investment funds might overlook some smaller profitable investments due to their lack of liquidity or low free float. Thus, an astute investor can make large profits by buying the next large cap at low prices, before the big guys buy in and raise the price. As small caps are mostly local companies, or constrained to one country, they should not be affected by macroeconomic influences like slower Chinese growth or the strong dollar. A technical reason to invest in small caps is that they have underperformed the market in the last 5 years and now might be a good time to change the weighting of a portfolio from blue chips to small caps.

Historical Performance

The most popular index for tracking small cap returns is the Russel 2000 Index which comprises 2,000 small cap companies from the US. The Russel 2000 has returned 33.6% in the last 5 years and underperformed the S&P 500 which returned 52%.

1 figure 1 SandP 500 russel 2000

Figure 1: Russel 2000 and S&P 500 5-year performance. Source: Bloomberg.

The underperformance was probably caused by increased turmoil in junk bond markets and financing difficulties while big companies continue to enjoy low interest rates.

But, underperformance could indicate an opposite effect in the future as both indices are well diversified and their performance should reflect the US economy. Also, analysts expect the Russel 2000 earnings to grow by 9.6% in 2016 and S&P 500 earnings to be flattish. From a fundamental perspective the PE ratio is on the S&P 500 side at 24.12 while the Russel 2000 has an incredible 401.25. Although, 2016 estimates are on Russel’s side, with 17.52 versus the S&P 500’s 17.65. The high current Russel 2000 PE ratio is probably related to the fact that many small US companies are in the US shale oil sector which has been battered in 2015 and continues to fall as many companies file for bankruptcy.

Risks of Investing in Small Caps

Small companies tend to be more uncertain than their bigger counterparts. There is no loyal customer base, operational history and every project immediately looks riskier. It is always easier for the big fish in the pond to weather storms, correct mistakes or grasp opportunities. Ownership is more concentrated and there is a lower trading volume and free float. A low free float makes a stock vulnerable to short attacks.

Small caps have limited access to capital and the current increases in interest rates create more future uncertainty. Limited access to capital makes small caps reluctant to pay dividends as available capital is steered towards growth investments. Information is also scarce, analysts may have limited access to financial statements prior to an IPO and future forecasts are based on less reliable information.

2 figure coverage

Figure 2: Number of analysts and coverage. Source: New York University.

But, the low coverage percentage and limited number of analysts creates opportunities.

Advantages of Investing  

Low coverage might enable a stock picking investor to discover a gem and create returns that cover for all the risks. A small starting base makes growth easier and especially in a quickly evolving digital world, small caps have the ability to change strategy faster than large caps. Aside from stock picking, a small cap index fund can also bring good returns. Historically the longer the investing period the higher the small cap returns and the certainty of over performance are.

3 large small cap

Figure 3: Time horizon and small firm premium. Source: New York University.

The average return for small caps from 1930 to 2013 was 12.7% while the S&P 500 index returned 9.7% and as the above research shows in any period longer than 20 years small caps have always outperformed the S&P 500 index.

US or International Small Caps

The small cap over performance holds its grounds also on a global level. Only in Norway, Denmark and Italy did small caps not earn a premium in relation to large caps in the long term.

4 global prem

Figure 4: Annual premium earned by small cap over large cap stocks. Source: New York University.

Investing Opportunities

The first investing strategy is to look for small caps that give quality diversification to a portfolio and allow it to hit the jack pot. This requires lots of an investor’s own due diligence as most of the small caps are poorly followed by analysts and they involve high risk.

The second potential investing strategy is to invest in small caps through index funds or ETFs. Besides the Russel 2000, the second most popular small cap index is the S&P Small Cap 600 index. As it does not include all small caps, it provides better sector diversification.

5 figure sector sap 600

Figure 5: S&P 600 sector breakdown. Source: S&P Dow Jones Indices.

A fund tracking the S&P 600 index is the Vanguard S&P Small-Cap 600 Index. For global ETF small cap diversification, opportunities include the SPDR S&P International Small Cap ETF that invests only in non US developed countries. The Vanguard FTSE All-World Ex US Small Cap ETF (VSS) provides a mix of developed and emerging small caps, and there are also much riskier emerging countries ETFs like the Market Vectors Brazil Small Cap ETF (BRF).


Investing in small caps can bring increased returns but it also increases risks as the volatility is much higher than for large caps. In any case, small caps should be a part of a well-diversified portfolio. Increased diversification can be achieved by going global.


There is a Huge GAP Between Reported and GAAP Earnings

  • Real earnings are currently 25% lower than pro forma reported ones.
  • The other consolidated income statement can also hide surprises.


How would life look if things were as you saw them or exactly like someone presented them? Surreal for sure as it would require a non-human mind to objectively process information and accept a situation as it is. People usually fall in love with the wrong person or feel depressed over nothing important. The same is applicable in business, but it’s strongly biased toward falling in love with one’s business and refusing to see the flaws of it. Such a behavior results in a large gap between pro forma reported earnings and official Generally Accepted Accounting Principles (GAAP) results.

Investors have to be mindful about that when analyzing earnings, and must precisely determine what the real situation is compared to managements’ rosier view. Even Buffett touched on the subject in his last letter to shareholders warning that “it has become common for managers to tell their owners to ignore certain expense items that are all too real” and analysts are part of the culprit as they propagate misleading numbers that can deceive investors.

Gap Between GAAP and Pro Forma Earnings is Widening

Pro forma figures exclude certain items that are considered by management as non-recurring. Some of those expense items include the costs of laying off workers, legal costs, acquisition expenses, cost of stock-based compensation, expenses related to asset volatility, asset write-downs, effects of foreign-currency moves, omitting results from newly opened and recently closed stores and depreciations not related to current operations. By eliminating noise, management’s intention is to present earnings related to the core business as what is happening around it is of no importance. The best way to explain what is going on is to let you read yourself. Apache Corporation (NYSE: APA) reported the following in its annual report:

For the year ending 2015, Apache reported a net loss of $23.1 billion, or $61.20 per diluted common share. On an adjusted basis, Apache’s 2015 loss totaled $130 million, or $0.34 per share. Net cash provided by continuing operating activities was approximately $2.8 billion, and adjusted EBITDA was $3.9 billion in 2015. Total capital expenditures were $4.7 billion for the full year, or $3.6 billion when excluding leasehold acquisitions, capitalized interest, Egypt noncontrolling interest, and spending on divested LNG and associated assets. This was at the low end of the company’s full-year 2015 guidance range of $3.6 to $3.8 billion.

APA’s management managed to turn a loss of $23 billion into an adjusted loss of $130 million and even finish with positive adjusted EBITDA of $3.9 billion. It is practically impossible for an investor not specialized in accounting to understand what is real and what not in such an annual report. Unfortunately, APA is not an exemption in the corporate world but more of a new mainstream.

1 figure gaap and pro forma

Figure 1: Gap between pro-forma and GAAP earnings widening. Source: The Wall Street Journal.

The official GAAP S&P 500 earnings in 2015 were $787 billion versus pro forma estimates of $1.04 billion which means that 25% of expenses are not treated by management as expenses but as mere non-recurring items. It is the widest difference since 2008 and a closer look shows that S&P 500 real GAAP earnings have not increased by 0.4% like pro forma earnings show, but instead declined by 12.7%. The issue is not only related to smaller companies like the above mentioned APA, but also to blue chips. 18 of the 30 Dow Jones Industrial Average (DJIA) members have reported higher pro forma than GAAP earnings.


Figure 2: DJIA average year-over-year change in EPS. Source: FACTSET.

Even blue chips report higher earnings than real earnings, and companies have had a history of treating the ordinary as extraordinary when business conditions worsen. In 2014, the difference between GAAP and pro forma earnings was 11.8% while in 2015 it jumped to 30.7% for the DJIA companies that report pro forma earnings.

3 difference 2014 2015

Figure 3: Difference between (%) pro forma and GAAP earnings for DJIA stocks. Source: FACTSET.

The most notable example from the DJIA is Merck (NYSE: MRK), who reported 2015 GAAP EPS of $1.56 and pro forma EPS of $3.59. The difference, according to management, comes from acquisition and divestiture related costs, restructuring costs and legal fees. The funny part is that in 2014 they excluded the same costs to form pro forma earnings and also forecast 2016 GAAP EPS to be between $1.96 and $2.23 while pro forma reported earnings are expected to be between $3.6 and $3.75. It seems illogical to name costs that occur year after year non-recurring.

Other Comprehensive Income

Another accounting issue that is not so much discussed about in the media is other comprehensive income (OCI). OCI includes revenues, expenses, gains, and losses under both GAAP and International Financial Reporting Standards (IFRS) that are excluded from net income on the income statement and are therefore listed after the income statement. Those items are mostly items that have not yet been realized and might change in the future. For example, an investment in a foreign country and currency is affected by currency fluctuations when the value is translated into the home currency. One year it can have a positive effect while the other a negative effect, therefore those differences are kept in the other comprehensive income statement until realized.

Items included in OCI and excluded from the income statement usually are:

  • Unrealized holding gains or losses on investments that are classified as available for sale.
  • Foreign currency translation gains or losses.
  • Pension plan gains or losses.

Before investing, it is good to take a look at accumulated OCI in order to see if the company has some huge unrealized future risks or benefits. Unfortunately the risks and unrealized losses are always wider than unrealized gains.


A good note for the average investor is that the SEC is looking at the issue and probably is going to regulate the way companies report earnings in order to limit the deceiving of investors. But, in the meantime, each investor should meticulously study the pro forma, GAAP and OCI earnings in order to estimate his investment. To conclude, Buffett applauds companies that report OCI income in the regular income statement and only real GAAP earnings.



Investment Opportunities in Iron Ore

  • Iron ore as a commodity faces long term oversupply.
  • The shift to a service oriented economy lowers Chinese steel demand growth.
  • Short term euphoria makes iron ore and related assets great for trading.


Iron ore is the world’s most mined and commonly used metal as 98% of it is used to make steel. As steel is mostly used for infrastructure and building it is not surprising that China is the world’s biggest consumer of iron. China produces 50% of the world’s steel output and 47% of the world’s iron ore.

Figure 1: Steel consumption in China and the world. Source: LKAB.

Therefore, China is the main factor for iron ore pricing. As Chinese demand for steel grew so did the price of iron ore. Increased iron ore prices brought increased investments in mining, and currently supply is higher than demand. In such a situation, a decline in prices is unavoidable and the decline in iron ore prices has been unstoppable for the last 5 years. From $180 per ton in 2011, the price of iron ore has eroded to the current price of around $60, but also reached prices below $40 in December 2015.

2 figure iron prices

Figure 2: Long term iron ore prices. Source: Iron Ore: Facts.

Unfortunately for iron ore miners, the outlook is not bright. The World Steel Association (WSA) is forecasting a decrease in steel demand in 2016 of 0.8% and just a slight increase of 0.4% in 2017. Also, unlike other commodities like copper, the world’s iron ore reserves seem enough for many more years of increased consumption. Estimated global reserves are 170 billion tons while current global consumption is 3.2 billion tons per year.

With low prices, high iron ore availability and lower demand for steel, logic would have miners lowering output in order to realign supply with demand to increase iron ore prices. But the world’s biggest miners have chosen a different way, one that has also strongly influenced the above price decline.

The Iron Ore Increased Supply Strategy

The strategy in the iron ore mining sector is one of increased supply in order to force high-cost supply to exit the market. The goal of such a strategy is to increase market share and reach higher profits with lower margins on bigger volumes. The world’s largest miners—Rio Tinto (NYSE: RIO), BHP Billiton (NYSE: BHP), Fortescue and Vale (NYSE: VALE)—are all increasing production. RIO and BHP require iron ore prices at around $25 to break even while Fortescue and VALE require prices to be around $40. 25% of global iron ore production has costs above the current spot price and most of the high cost producers are in China. Therefore, the big global miners hope to reach maximum profits by increasing production and completely conquering global markets.

3 figure cost curve

Figure 3: Iron ore cost curve. Source: Metalycs via

The strategy is not yet showing positive signs as all the above mentioned miners have reported losses (RIO and VALE) or minimal profits (BHP and Fortescue) in the last 4 quarters. In order to see if the strategy is going to pay off in the long term, it is necessary to look at the forecasts for iron ore.


In the short term iron ore prices have quickly recovered from this winter’s lows and are currently boosted by increased building expectations in China. But, Goldman Sachs is describing this increase in prices as temporary because there was no shift in raw-material fundamentals and expects iron ore prices to return to $35 per ton soon. Also, RIO and BHP have warned that prices will come down again.

A mid-term outlook shows that iron ore is bound to stay at low levels as the trade balance outlook remains highly positive through 2020.

4 figure trade balance

Figure 4: Iron ore China trade balance (price is from begin 2015 and has to be adjusted lower). Source: ABM Brasil.

The World Bank estimates that iron ore prices will be around $50 per ton for the next five years as the increase in low cost supply is much larger than the closures of high cost mines.

In the long term, iron ore prices are completely dependent on steel demand and steel demand is not expected to grow at the same rates it used to grow in the last 15 years.

5 figure steel demand forecast

Figure 5: Steel demand forecast. Source: ABM Brasil.

As a country becomes more developed the infrastructure and building necessities become more service oriented and therefore demand for steel diminishes. A case for steel would logically be India as the successor of China in growth and infrastructure building, but it is forecasted that India will mostly be self-sufficient in its steel production.

As low commodity prices limit new investments and commodities are cyclical, somewhere down the line another surge in iron ore prices can be expected. But, according to Wood Mackenzie such a situation should only emerge after 2025 or even later, as current capacity is enough to cover demand and increased production will probably lead to a long term oversupply.

7 figure supply

Figure 6: Supply comfortably exceeds demand for the next two decades. Source: Wood Mackenzie.


Considering everything above, iron ore seems a tricky asset. High availability excludes a copper scenario where it is known that mine grades are bound to be lower in the future. Long term oversupply and a shift in the Chinese economy from a manufacturing and heavy infrastructure investing one to a more service oriented one does not make a strong case for iron. But, iron ore prices have fallen more than 75% from their 2011 peak so there should be opportunities to make profits. Perhaps iron ore should be left to traders that have the stomach to weather huge swings and the knowledge to seize the volatility as the price is influenced by oversupply in the long term but also by short term euphoria like the in the last two months based on increased lending and hopes of a return to previous levels in Chinese infrastructure growth.



Tax Holiday Could Repatriate $2.1 Trillion

  • US companies have more than $2.1 trillion abroad.
  • 12 years have passed since the last tax holiday.


A tax holiday is a government incentive to businesses where it lowers or eliminates a tax for a period of time. The most interesting tax holiday for investors is a corporate income tax holiday on the repatriation of foreign cash. Typically, any repatriated cash is subject to a 35% corporate income tax and therefore US corporations are reluctant to repatriate it and keep their cash abroad. The last tax holiday was voted by Congress in 2004 when companies where allowed to repatriate cash at a 5.25% tax rate. Many companies took advantage and repatriated billions of dollars. 12 years have passed since then and it is time to look at what the investment opportunities are related to an eventual new tax holiday.

Current Situation

As 12 years have passed since the last tax holiday, US companies have stashed billions of cash abroad. The leader is Apple Inc. (Nasdaq: AAPL) with 93% of its $232 billion of cash and marketable securities abroad. If that cash would be repatriated now, AAPL would have to pay $75 billion in US taxes. In the meantime, AAPL’s cash is invested in marketable securities and earning interest. Alphabet Inc. (Nasdaq: GOOG) also has a large percentage (not disclosed) of its $75 billion cash and marketable securities abroad.

A report from October 2015 estimates that US companies hold $2.1 trillion overseas and by doing so avoid paying $620 billion in taxes. The below figure shows the companies with the largest overseas cash balances and how much they have stored overseas.

1 figure 2014

Figure 1: Overseas cash balances at the end of 2014. Source: US PIRG & CTJ.

As the above data is from 2014, the total amount of cash abroad has surely increased due to the high overseas profits US corporations have. All this cash could do wonders for the US economy, businesses and the stock market, but this is more of a political rather than an investing or economic issue for now.

Political Aspect

As the US GDP is around $18 trillion, the $2.1 trillion in cash abroad owned by US companies is a sweet and attractive cake. As companies are taxed on an individual legal entity basis, there is no legal way of forcing companies to repatriate cash and pay US corporate income tax on it because the US has no jurisdiction on their foreign subsidiaries. Therefore, in order to get some benefits, the US government could allow a tax holiday. A holiday would not mean that corporations pay nothing, but that the tax is lowered to a point where corporations find it attractive to bring the cash back home. A low tax would also create an immediate benefit for the US. The last time there was a vote for a proposed tax holiday in 2009, the US Senate voted against such a proposal. The vote was mostly based on the US Senate’s research on the last tax holiday when in 2004 the America Jobs Creation Act (AJCA) permitted U.S. corporations to repatriate income held outside of the US at an effective tax rate of 5.25% instead of the top 35% corporate income tax rate. Proponents of the tax provision argued that increased domestic cash would spur investments and job creation. But, as the research shows that was not the case; US jobs lost rather than gained because the top 15 repatriating companies reduced their workforce by 20,931 while stock repurchases and executives’ compensation increased. Of course, such a report has to be taken with a grain of salt because several other factors affect jobs and corporate politics other than repatriations and there is no counter test to see what would have been the effect on jobs without the tax holiday.

There is continuous lobbying for a tax holiday and we will have to see how the current slowdown in GDP growth will affect decision makers. The last commotion around a tax holiday was in 2014 when APPL’s CEO Tim Cook commented that the 35% tax rate on repatriated cash is a very high number and that APPL would repatriate at a lower, more reasonable tax rate. A senatorial discussion followed but no action was taken. Perhaps after the presidential elections and, hopefully not, after an economic slowdown the tax repatriation holiday might become a hot topic again.


It seems that Wall Street does not value cash abroad at face value, but instead discounts it by the full corporate income tax. The result is that AAPL is valued at a PE ratio around 11. Any indication of a tax holiday would give a quick boost to the companies mentioned in figure 1 as $2.1 trillion could be redistributed to shareholders via dividends and repurchases or used for acquisitions. Even if a tax holiday is not voted on soon, it always remains a nice buffer for the mentioned companies in case of a market downturn.