The Limerick of Finance for 01/31/16

Chinese copycats steal at will
Cheap knock-offs still give them a thrill
They make a quick buck
Counting only on luck
Cashing in on some grey market bill

China's Shanzhai Economy Mocks Innovation

China has a long tradition of "shanzhai" knock-off goods. Companies shamelessly copying global brands without compensation or even attribution contribute to China's poor reputation for quality manufacturing and intellectual property (IP) protection. Shanzhai extends to more than just brand image. It permeates every aspect of China's allegedly miraculous growth, including real property and government statistics. Its persistence poses risks to Western investors who underestimate China's resistance to cultural change.

PwC republished Booz's 2009 report regarding shanzhai as an innovative phenomenon. It may have appeared innovative when China was trying to convince the West that its booming production would translate into what we would recognize as an advanced economy. Things never worked out that way. Breakneck production without the rule of law to protect innovation eventually turns off international investors.

China somehow managed to fool amateur observers into thinking that everything would be okay once it grew out of its wild frontier phase. The Atlantic in 2014 interpreted shanzhai as an evolutionary crowdsourced ecosystem for innovation. Silicon Valley would recognize innovation without IP protection or market share as an invitation to further piracy. The Wall Street Journal had a similar analytical lapse in 2009, more from a political and cultural standpoint. Astute observers integrate social and political trends into economic analysis if they understand those trends from a native perspective.

Native mainland Chinese have not developed the legal and political traditions the Anglo-West relies upon to protect property rights, including IP. Some Chinese innovator making shanzhai wearable tech is unconcerned with the product quality or global branding that leads to defensible market share. They're still in it for the fast buck because they cannot count on legal protection outside China or political protection within China. Western observers who cannot see shanzhai through Chinese eyes would find this inscrutable. Personal connections through "guanxi" matter more than rules and laws. The Chinese Commonwealth "bamboo network" diaspora matters more than sovereign trade agreements. The West continues to misinterpret these concepts by pretending to see in China what it wants to see in its own culture.

Shanzhai has metastasized beyond consumer goods into real property. Freakonomics noted in 2013 how shanzhai skyscrapers copy other popular building designs. Run a Google image search of China's property boom to see entire cities containing replicas of Paris' Eiffel Tower, quaint European town squares, and parts of Manhattan. China's government economic statistics have long been unreliable, according to descriptions of the Keqiang Index. Replacing that index with something the UNDP or WTO can audit would be a sound step. Instead, the WSJ reported in 2015 that China's State Council would replace the Keqiang Index with measures tracking quality of life. The state is acting in the spirit of shanzhai innovation, copying Western ideas wholesale without grokking how enforcing laws means breaking personal ties.

The shanzhai apotheosis is a huge red flag for US investors with exposure to China. Mainland China's economic growth is more mirage than reality, notwithstanding CSIS's "Broken Abacus" 2015 nonsense that China's economy is bigger than what it self-reports. Try reconciling national-level economic data with provincial-level data and see how China's national authorities guide subordinate governments into supporting its fabrications. Investors betting on US-traded instruments for Chinese stocks or ETFs are gambling that reality will eventually catch up to fantasy. Shanzhai's continued dominance of Chinese business culture makes that a poor gamble.

Full disclosure: No positions in any Chinese investments. BTW, I have corrected the spelling of "shanzhai" after publishing this article.

Financial Sarcasm Roundup for 01/31/16

Sarcasm on Sunday is way better than attending church. You could listen to some preacher lie about the nature of the universe, or you can listen to me tell the truth about finance.

Alphabet and Apple battle it out for the valuation world heavyweight championship. Both companies are symptoms of the Silicon Valley tech bubble. Investors have chased these stocks because ZIRP made savings accounts look stupid. Apple's (AAPL) P/E is deceptively low at 10 and Alphabet's (GOOG) is really high at 31. Both companies depend very much on smartphone users replacing costly phones more often than necessary in the developed world's saturated markets. Financial advisers who toggle their portfolio optimization searches with "high risk" aren't doing their risk-averse clients any favors by selecting overpriced tech stocks.

The IMF and its lending cartel will review Greece's bailout progress. It's really sick how the world's most important financiers play "extend and pretend" with a country that has no interest in paying its debts. Forcing losses on creditors would clear up credit quality questions a lot faster than extending maturities. I would have hung the foreclosure sign on the Acropolis by now but the IMF never called me to ask for advice. Athens should hire me to fix their problems if they can pay me in something other than gyros (which I really like to eat BTW).

Big SIFIs are cutting the biggest deals with the SEC to settle dark pool allegations. I have always wondered why investors deliberately walk into something they know is dark. The banks telling investors they will get the best execution in dark pools are also the same source of prime brokerage credit for HFT hedge funds trading in those pools. Willfully blind investors, duplicitous banks, and greedy HFTs all jumped into those dark pools to rip each other off. The traditional investors are always the dumbest money in the room, so of course they got taken to the cleaners.

I told you this was better than a church sermon. I'm more entertaining and honest than any religious leader. I should start my own religion so people can properly worship me.

The Haiku of Finance for 01/30/16

Energy market
Demand for cheapest sources
Cost of pollution

Financial Sarcasm Roundup for 01/30/16

Saturday is supposed to be a slow news day, but it's never too slow for sarcasm.

The US economy probably slowed down in Q4 2015. Business surveys from the private sector are probably more reliable than government figures. Federal agencies have been monkeying around with their methodologies for too long under political pressure to report rosy results. Voters get fed up with ruling elites when official results don't square with daily life. The next administration can do a lot to restore Americans' confidence in government just by reporting honest numbers.

The Zika virus is boosting a few life science stocks. Curing disease is a good reason to invest in drug makers. Day trading a stock with the expectation that disasters will pump a quick profit is immoral, not to mention just plain stupid. There is no assurance that the UN WHO or any other powerful body will hand these companies a contract. Greed and wishful thinking drive dumb investor reactions to headline dangers. There is no drug to cure stupidity.

Hedge funds misjudged the yen. The BOJ invalidated a whole bunch of investment philosophies overnight. I've said before that currency positions are useful mainly as hedges for cash reserves, not pure-play bets. Hedge funds are running out of ideas if they think betting big on a currency is innovative. George Soros made a big currency bet once against the British pound and it worked once. There is no law that says it must keep working. People running hedge funds can work as janitors after the yen bankrupts them.

Xerox is splitting itself. Carl Icahn wins again. I've always admired the guy because he forces companies to do right by their shareholders. He would probably make an excellent US Treasury secretary if Donald Trump wins the presidential election. I would like to see some corporate raiders and deal-makers break up some of the US government's less efficient agencies. Privatizing Social Security and Medicare could work like an insurance company spin-off. I wouldn't buy those split stocks because I've read the Bowles-Simpson reports on those entities' eventual insolvency, but some mutual fund manager is dumb enough to go for it.

Most writers would sign off by saying they hope everyone else's Saturday is going well. I'm not like most writers. I don't care about how your Saturday is going. My Saturdays are the definition of awesome.

The Haiku of Finance for 01/29/16

Microcap sector
Track imperfect trend data
Benchmarks not so great

Small Business Indicators For Microcap Sector Choices

Microcap stocks are notoriously hard nuts to crack. They are the part of the capitalization-weighted investment universe that is typically less liquid, transparent, and profitable than large-cap choices. Investors do have some indicators they can use to estimate turning points in the microcap sector's aggregate health. A small number of microcap ETFs help diversify away company-specific risk.

The NFIB's Small Business Economic Trends (SBET) is one possible proxy for the sentiment of small business owner-investors. It combines data on both future plans and current results. The December 2015 report puts the Index of Small Business Optimism at 95.2, below the long-term average of 98. The small sample size and seasonal adjustments limit the index's usefulness. The SBET also does not disclose the average revenue, net income, or asset quality of its sampled businesses, so investors cannot presume any strong equivalency with microcap stocks.

The Wells Fargo / Gallup Small Business Index is probably a more robust indicator than the NFIB SBET. Gallup's index methodology also relies upon a small sample size but discloses a revenue range that could easily include the lower bound of the microcap sector's revenues. The index is one more addition to an investor's toolkit. BTW, this index also registered a decline in optimism in late 2015.

The Paychex IHS Small Business Jobs Index covers a vast sample size, so data quality here is less of a concern than with the previous two indexes. Measuring job growth helps investors determine whether small companies can afford to expand and handle higher sales volumes. Job gains at the end of 2015 were on a slight downward trend since early 2014, punctuated by some up months.

Dun and Bradstreet’s U.S. Economic Health Tracker covers a Small Business Health Index for payments and credit, with a large data set. The Tracker shows small business performance worsening so far this year, with weak payment performance. That makes two weak optimism indexes, a declining jobs index, and a weak payment/credit health index so far to start 2016.

Our macroeconomic data indicators for small businesses are not the only ways to understand microcaps. Investors need to know how different index providers assemble the microcap universe, because this ultimately determines ETF composition. The Boglehead wiki on US micro cap index returns compares several microcap indexes. The Wilshire index has the longest history, so performance data for products based on that index would be the most reliable.

Only a small number of ETFs cover the microcap sector. PowerShares Zacks Micro Cap ETF (ticker PZI, expense ratio 0.70%) and First Trust Dow Jones Select MicroCap ETF (ticker FDM, expense ratio 0.60%) are very thinly traded. Investors will face more difficulty with trade execution in thinly-traded securities. The Zacks product follows a proprietary index and the First Trust product follows a select index, so their returns are not directly comparable to those of ETFs that follow wider indexes.

The iShares Micro-Cap ETF (ticker IWC, expense ratio 0.60%) is more actively traded and has a larger market capitalization than PZI or FDM, and its construction from the Russell Microcap Index makes its methodology more reliable. Other details are less encouraging. It is currently heavily weighted toward the finance, health care, and information technology sectors. Those areas are all very much in bubble territory thanks to the Federal Reserve's easy credit (finance), unsustainable Medicare payouts (health care), and VC-funded startup unicorns gorging on cloud services (IT). Consider also how the R-squared result for IWC (at its Yahoo Finance risk data) declined from 77.77 at the 10-year mark to 47.66 in the most recent three-year period. The more recent period's performance thus has progressively less to do with the underlying index. That is a worrisome sign for an ETF that is supposed to stay very close to an index's results.

Investors are welcome to track the above four macro indicators and relate them to the microcap sector's leading products. Weakening indicators imply tougher times for small businesses. Leading index products that are increasingly divergent from their benchmarks (and more expensive than large-cap ETFs) are causes for concern.

The sad tales of microcap stock promotions gone wrong are always with us. The bad old days of investor relations conferences and seminars have given way to spam email stock scam promotions. Microcaps are easy prey for all manner of bad actors. The most broadly diversified instruments will at least give investors exposure to larger trends that can lift young, high-risk public companies to larger capitalizations.

Full disclosure: No positions in any securities mentioned.

Financial Sarcasm Roundup for 01/29/16

People take self-identification to new extremes in the digital age. I self-identify as sarcastic, which ought to be a distinct personality type.

Japan's central bank goes for negative interest rates. That should pry the last yen out from under savers' mattresses and push Japanese investors into riskier territory. The positive feedback loop from such a nonsensical policy will never solve Japan's structural problems. Switzerland did this for a while but they had a strong currency. Japan's results will be worse.

Puerto Rico expects to issue new debt. The old debt isn't working out too well, so the new stuff will have to pay junk-bond type interest. Paying out 5% just isn't going to cut it with investors who got burned. No one likes taking a valuation haircut. I am so glad I never owned Puerto Rico bonds. They will make very nice wallpaper after several re-issues.

Theranos keeps having one problem after another. Specious tech claims and poor lab conditions should not justify a multi-billion dollar private market valuation. A whole bunch of top-shelf VC firms have staked their reputations on a business they never understood. I can imagine the panicked phone calls up and down Sand Hill Road about what desperate measures anyone can take to keep this unicorn from tipping over. Save the energy for the post-mortem court cases, people.

I may try self-identifying as a housecat just to see how people react. Nah, just kidding.

The Haiku of Finance for 01/28/16

Safely transport oil
Pipelines are still the best way
Railcars come second

Safely Transporting Oil By Railroad

The oil price crash impacts the railroad sector. Transporting freight gets cheaper, but demand for railcars to bring oil out of the Bakken fields and other places where pipelines were never laid is now dropping off. Refer to US DOT MARAD's 2008 study "Impact of High Oil Prices on Freight Transportation" for technical discussions of how the rail sector behaved under different conditions. Times have changed, perhaps permanently. Safety rules can also change with the times.

Railroad accidents made headlines when America's oil shale boom was roaring. Horrific, sensational railcar explosions are less useful justifications for transportation policymaking than statistics. The US DOT's Federal Railroad Administration (FRA) Office of Safety Analysis has the data. Running a ten-year report shows that total accidents declined by over 31% from 2006 to 2015, with percentage declines in every single subcategory. Rail transport has gotten safer than ever during the oil shale boom.

Oil shale's critics used to claim that Bakken oil was more volatile and thus more dangerous to ship in railcars. The National Transportation Safety Board's (NTSB) chair debunked this claim after some high-profile accidents. A refining industry study also found that Bakken crude fits within existing oil safety standards. The volume of fuel spilled, not its chemical composition, determines its potential hazard. Anyone can search the American Fuel and Petrochemical Manufacturers (AFPM) website for "Bakken crude" and see the evidence.

Forest Ethics does the public a disservice with its alarmist Oil Train Blast Zone tool. The relatively small number of rail accidents could never endanger millions of Americans, as the tool misleadingly implies. Requiring railroad operating companies to emplace blast barriers around every yard and connecting track in populated areas would be costly and probably unnecessary. It would be better for the railroad industry, along with FRA and NTSB, to take a Six Sigma approach to estimating deaths from oil-related transport accidents. Reducing mortality is important and statistics will show us exactly which locations need better safety measures.

Policy advocates are often remarkably ignorant of science, math, and economics. I don't think a typical anti-hydrocarbon advocate can perform an energy returned on energy invested (EROEI) comparison between biofuels (for example) and hydrocarbon fuels. They are welcome to start with refining and transport data from the Western States Petroleum Association and the California Energy Commission but I don't think they'll have the patience to get very far.

I am not prepared to demonize tar sands and oil shale as "extreme fuels" in the style of some renewable energy advocates. Hydrocarbon energy will be part of human life for a few more decades until renewable energy's infrastructure catches up. Pipelines are the safest and cheapest way to transport oil over long distances. Railcars are still the next best way despite the pleadings of safety paranoiacs.

Financial Sarcasm Roundup for 01/28/16

Hatred and love are powerful emotions. Sarcasm is not an emotion but it may be even more powerful.

The Federal Reserve made markets nervous yesterday. I say tough luck for wimpy stock market experts. Big players have had it too easy with ZIRP subsidizing their gambling. Moving toward a more historically normal interest rate environment means crybaby institutional investors will lose money. Just look at the confused commentary coming from Wall Street's idiots. They don't remember what normal feels like and their bond trading desks are full of Millennial whipper-snappers who think credit is always free.

The US Treasury alerts us to derivatives clearinghouse risks. That sure throws some cold water on the theory that transparency and mark-to-market pricing would make derivatives less threatening to the economy. The Fed and SEC have planned for trading halts and fund backstops. Now they need to think about liquidity backstops for clearinghouses. I suspect that will be a bridge too far in a crisis, so AIG-style instant firm resolutions will be the preferred risk mitigation tactic instead.

China's statistics chief is in trouble. Beijing couldn't keep their numbers frauds hidden forever and now they need a public scapegoat in true Manchurian style. The news may fool a few Western investment firms (the ones that don't understand China) into thinking things will get better when the head stats guy is replaced. A couple of high-profile career terminations won't stop the Chinese stock market's slide.

I try really hard not to hate people, even if they deserve it. Hateful people deserve sarcasm instead.

The Haiku of Finance for 01/27/16

Over-rated stuff
Eventual implosion
More chances to short

Financial Sarcasm Roundup for 01/27/16

It's not enough to have weekly sarcasm. I need to exhibit daily sarcasm. Alfidi Capital must be the unchallenged premium source of financial sarcasm every time the sun rises.

Iran's president says getting filthy rich cures radical nutjobs. He didn't quite say it like that but I like to think that's what he meant in translation. Reuters is too kind to quote heads of state that way. Iran is about to unlock $150B in frozen assets and return to exporting oil as sanctions are lifted. It pays to play nice with one's neighbors. Iran should spend that windfall on something other than harassing student protesters. Meeting the Pope may be the key to convincing Rome's street vendors to import Iranian lavashak (a.k.a. Persian fruit leather, or pressed fruit rolls). I smell a sweet deal.

Credit rating agencies are still messed up. It's about time regulators squeezed these people until they squeal. Selling ratings for MBS and other garbage helped cause the 2008 financial crisis. Dumb money does not perform due diligence even one level deep, let alone for the two or three levels needed to understand securitized products. Continued problems will bring another chance to short every falsely rated financial product in sight.

The corporate debt mountain is ready to topple. Bring on the implosion. Publicly held companies that can't service their debt will get wiped from indexes and bring shorting opportunities to patient investors like me. Defaulted corporate bonds and bankrupt ETF prospectuses will make nice art projects.

I can really get used to a daily sarcasm habit. I will enjoy force-feeding this diet to my regular readers. Eat it, people.

The Haiku of Finance for 01/26/16

Eat bread in a tweet
Diet stock jumps on the news
Tasty fat profit

Regulatory Risks Of Leveraging Federal Lab Innovation

The Federal Laboratory Consortium is a gold mine begging for exploration. Technology gathering dust in lab basements and filing cabinets needs entrepreneurs to make it economically viable. The regulatory landscape has holes at the federal level that beg to be filled. Here are some Alfidi Capital tips for small and medium-sized businesses (SMBs) looking to make tech innovation work while avoiding regulatory traps.

The Brookings Institution published "Going Local" in 2014 about how DOE's labs should support regional economic growth. White papers are full of ideas that gather dust, just like great tech ideas without people implementing them. The lead time for processing a cooperative research and development agreement (CRADA) or a work for other agreement (WFO) may be too long for specific product development but just right for a basic tech demonstration. The SMB moving a tech concept out of the lab's basement may be suited for small-scale funding typical of the NREL's technical and analytical service agreements.

The President's Council of Advisors on Science and Technology (PCAST) report "Big Data: A Technological Perspective" from 2014 will set federal policy on data privacy for years. Government regulations crossing multiple agencies' jurisdictions has a way of guaranteeing a market for products. Large firms faced with the regulatory risk of meeting Big Data privacy mandates will need solutions. Small firms should factor privacy compliance into their product development milestones.

The American Academy of Arts and Sciences report "Restoring the Foundation" in 2014 recommended permanent Presidential attention to R+D spending. Federal tech funding as a GDP percentage cannot stagnate forever. Its eventual recovery will provide funding opportunities for SMBs ready to jump into grants and contracts.

Watching the slow progress in implementing all of these reports' recommendations is disheartening. Untangling the jumble of federal advisory committees shepherding regulatory reform is outside the private sector's control, unless the President appoints business-friendly people to run the process. American SMBs cannot wait for reform. They should master the funding application system now and gain experience working through the system.