A Crisis of Confidence

Americans have come to rely on "crises" to help the economy…following each disaster, the Fed has refrained from raising rates, and fired up the printing press. Marc Faber explains why investors should not count on the easy-money band-aid to help them profit…

Since late April the U.S. stock market has rallied strongly. (The S&P 500 is up by 5.5 percent but still down one percent year-to date.) In particular, the Nasdaq 100 had a powerful recovery move. From its April 29 intraday low of below 1400, it rose as of this writing [June 15, 2005] by 11.2 percent. In Europe, several stock markets broke out above their March highs (not the UK market), but strong gains in equities were largely offset by Euro weakness.

Therefore, while the German DAX is up by 5.2 percent year-to-date, in U.S. dollar terms it is down 3.2 percent. Similarly, the Swiss Market Index is up year-to-date by 8 percent, but in dollar terms it is down by 0.4 In Asia, the performance has so far been disappointing. There are several factors that may have contributed to this powerful recovery move.

Strength in the U.S. dollar and diminished worries about consumer price inflation, which propelled bond prices to their February 2005 highs, also contributed to an improvement in sentiment. In this respect, it should be noted that by late April, investors’ sentiment had become rather gloomy. There were rumors about problems at several hedge funds and, following the dismal performance of the first quarter and the inability of the stock market to rally in the usually seasonally strong month of April, investors were about to give up on equities.

So, given the perceived problems in the hedge fund industry and the slowdown in global economic growth, investors figured that the Federal Reserve Board would shortly stop raising the Fed Fund rate and, if there was indeed a problem with some financial institution, the Fed would do what it had always done in the past, which is to ease and to print money. Each time the Fed tightened monetary conditions, something "bad" occurred. But equally, each time a crisis occurred, the response was swift and massive easing, followed by rate cuts.

Needless to say, the maestro at repeatedly printing money in the wake of crises – and particularly since 1997 – was none other than Mr. Greenspan. In other words, investors now perceive that an economic slowdown, or a crisis at one or several hedge funds, will induce the Fed to refrain from raising rates further and once again to turn on the money printing press.

After all, MZM has been growing recently at its lowest rate in ten years, indicating currently much tighter monetary policies and, therefore, leaving ample room for renewed easing at the first sign of any problem for the economy or the financial system. And since investors have been conditioned over the last 20 years or so to buy into crises, because following each crisis the market has soared, they are now buying in expectation of a crisis, which would force the Fed to ease. The present investment environment must therefore be described as bizarre!

Federal Reserve Intervention: Longing for a Financial Accident

Investors are ardently longing for a poor economy or a financial accident, under the assumption that such eventualities will be favorable for the already highly inflated asset markets. However, and this should be weighted by investors carefully, the strategy of buying stocks on the basis of slower economic growth or a crisis entails very high risk. For one, we don’t know how severe any slowdown may be. Under some conditions, a slowdown could lead to a global slump – especially if the U.S. housing market was to break at the same time that China’s economy, plagued by huge overcapacities, imploded.

Whether, in such a situation, easy money would solve any problem is debatable, for two reasons. In the past, whenever there was a crisis, there was a flight to safety. Investors immediately bought U.S. government bonds in the hope that interest rates would come down and knowing that interest and principal on Treasuries were 100% safe.

However, it is far from certain that cutting the Fed Fund rate in future will produce the same reaction. It is possible that investors, seeing the Fed easing once more, will grow apprehensive about future consumer price increases and, instead of buying long-term Treasuries, will sell them, thus increasing long-term interest rates. If eight Fed Fund rate increases haven’t yet led to any bond market weakness but, rather, to strength, who is to know whether future cuts in short-term rates might not lead to bonds selling off?

Also, since most of the crises experienced over the last 15 years, beginning with the Persian Gulf crisis of 1990, were related to problems outside the United States, there was a flight of safety into U.S. Treasury bonds not only by domestic investors, but also by international ones. This, in turn, tended to strengthen the U.S. dollar in times of crisis. But, what if the Fed were to embark on a massive money printing operation because of a really nasty economic surprise or financial accident in the United States? Would foreign investors still consider the U.S. dollar and U.S. bonds to be safe? I doubt it.

Under such circumstances a far more likely outcome would be a tsunami of dollar selling and, along with it, selling of U.S. dollar bonds. In the wake of massive selling of dollars and dollar bonds by foreign investors, interest rates would likely rise. In turn, this would force the Fed to monetize even more. A further loss of confidence in the dollar would follow.

The question here is, what would the dollar sell off against, and what would investors perceive as a safe haven in such a situation? The Euro? Not very likely! Asian currencies? Possibly, but if China were to weaken simultaneously with the U.S. economy it’s unlikely that Asian currencies would be viewed as a safe haven. I suppose that in a crisis of confidence arising from an economic or financial problem in the United States of a scale that would lead the Fed to print money in massive quantities, only gold, silver, and platinum would be regarded as truly safe currencies notwithstanding their current weakness.

There is, of course, always the possibility that the global economy might weaken or that a crisis might occur while U.S. residential property is still accelerating on the upside.

Federal Reserve Intervention: Dilemma

Under these conditions, the Fed would face a serious dilemma (a dilemma it faces already to some extent). Easy money might alleviate the economic or financial problems (though not solve them), but at the expense of extending the housing inflation further and making it even more dangerous for the economy once the housing bubble bursts at a later stage. I have recently received many emails from investors questioning the view that a bubble had developed in some housing markets around the world. Needless to say, these emails remind me of the emails I received in 1999 concerning my negative views about the Nasdaq.

There is another reason for labeling the current U.S. stock market rally as a high-risk move. Usually, strong stock market moves are led, or at least confirmed, by brokerage shares moving higher. While the world’s largest retailer, Wal-Mart (WMT), is no longer declining in price, its recent disappointing market action doesn’t suggest a very strong consumption environment.

High-tech shares have recently begun to outperform the market, and this trend could last for another few months as performance-minded fund managers shift out of economic sensitive companies into high-tech companies based on hope and momentum. And while this strategy may work for a while, it is also riddled with risks. Take semiconductors. The Sox Index has risen from its late April low by 15 percent and looks technically strong – albeit near-term overbought. Worldwide semiconductor sales, which recovered from their 2000/2001 slump, have recovered, but at $220 billion annually are barely higher than in 2000. However, the composition of semiconductor sales has changed markedly since 2000. Whereas in the United States and Europe the recovery in sales has been tenuous at best (in the U.S., semiconductor sales are no higher than in 1995, because of product price declines and sluggish demand), in Asia, sales have been booming until just recently.

Now, if Jim Walker and Simon Hunt are right about a meaningful slowdown in the Chinese economy coming shortly, it is likely that Asian semiconductor sales will fail to rise, or may even decline, at precisely the time when large new production capacities will be coming into production. This is hardly a very favorable fundamental outlook for this still highly valued industry! I also fail to see why semiconductors would be less economic-sensitive than the copper, shipping, or steel industries.

So, once again, by moving into semiconductor and other high-tech companies we are faced with a relatively high-risk trade, which may nevertheless work for a while due to the momentum players.

In sum, we continue to recommend a very cautious posture regarding equity investments. Near term, the United States and most European stock markets seem overbought, whereby following some consolidation further temporary bouts of strength cannot be ruled out. But, as we have indicated, investing in an environment of a global economic slowdown is a high-risk proposition for all asset classes, as the severity of the slowdown or economic slump is unknown.

This is especially the case if one is faced with mostly inflated assets, a disproportionately large and highly leveraged financial sector, and a central planner – the Federal Reserve – that repeatedly intervenes in the free market for money and whose intentions are nebulous!

Regards,

Marc Faber
for The Daily Reckoning

June 28, 2005

Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow’s Gold, one of the best investment books on the market.

Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.

Dr. Faber is a regular contributor to Whiskey and Gunpowder, free e-newsletter, from Dan Denning and Byron King (among others) that covers resources, oil, geopolitics, military history, geology and personal freedom.

First, the Chinese bought IBM’s personal computer company. Now, they’ve got bids out for Maytag and Unocal. Soon, it will be GM and Microsoft, says William Pesek at Bloomberg.

Everyone seems to have an opinion, but on the subject of globalization every opinion is moronic.

On the one side are the free traders, such as George W. Bush and Thomas L. Friedman. They say they’re for free trade as a matter of principle. Virtue is what used to pay, as Gordon Tullock put it. The free traders believe in free trade because it once paid. When America had a positive trade balance she gained from having open access to as many markets as possible; her industries could produce at lower costs by outsourcing and they could sell to whomever they could reach.

But that was when manufacturing was still a major part of the U.S. economy, when people still saved their money and invested it in newer, better, and faster production facilities, and when people still used the expression "you can’t get something for nothing."

Now, the nation’s attention has shifted from making money to spending it; the nation’s favorite business is no longer a manufacturer, GM, but a retailer, Wal-Mart; and "something for nothing" is practically the national motto.

Free trade still benefits Americans; it permits them to squander their wealth on more favorable terms. As they trade their homes and homeland companies for geegaws and gadgets, they get more for their money. But each day that passes makes them poorer; that is what happens when you spend more than you earn. Many of America’s most important businesses are no longer competitive on world markets. Free trade or not, the wealth advantage that Americans enjoyed from WWI to the mid-’80s has packed its bags and is moving East. Open markets, and E-Z credit terms, just speed up the process. And when the free traders finally figure it out, we predict that they will become more protectionist than even Smoot or Hawley.

But that is still for the future. Right now, most Americans still think they have the world’s most flexible and dynamic economy. They support free trade because they think it still pays.

On the other side are those who think free trade never pays. Someone sent us a review from Patrick Buchanan’s recent book, THE GREAT BETRAYAL; How American Sovereignty and Social Justice Are Being Sacrificed to the Gods of the Global Economy.

"Buchanan was a free trader as recently as 1987," begins the review. "So he is well versed in the free trade arguments.

"From 1821 to World War II, with short term exceptions, the American tariffs ranged from 25% to 50% with an average of 40%. This was the period of the American industrial revolution. America was built under the shield of protection. Then from World War II to 1970, tariffs were lowered to 12%. There after they were cut to 5%.

"All four presidents on Mt Rushmore were protectionists."

Buchanan shows us that protectionism has a long and honorable past in America. But what we see is only that the Land of the Free never was quite as free as we thought – at least in matters of international trade. He might as well argue that we should re-institute chattel slavery; people once thought that was a good idea too. They thought it was a good idea – like free trade – when it paid. When it stopped paying they changed their opinions.

Is Buchanan right? Does protectionism pay? Can America’s competitive advantage be restored with tariffs, taxes, and quotas? Can regression to the mean in world labor rates (the process of bringing wages in the West and the East back in balance) be arrested by passing laws? Can the American empire be preserved by stifling globalization?

We don’t think so, dear reader. More tomorrow….

For now, the news, from our team at The Rude Awakening:

————–

Eric Fry, reporting from Wall Street…

"Last year, China exported 504 million pairs of socks, 73 million cell phones…and 30 million tourists. Wanderlust, it seems, is but one of the many by-products of the flourishing Chinese economy."

————–

Bill Bonner, with more opinions:

"The year is 2050. The Middle Kingdom, formerly known as the People’s Republic of China, is the richest, most powerful nation on the planet. Its thousands of factories hum 24/7, cranking out 60 percent of the world’s textiles, sophisticated electronics and computers for the world’s IT industry, and over 40 percent of all cars – including the largest auto company in the world, General Motors International, a Chinese blue chip."

So begins the last chapter of Dan Denning’s newly released book, The Bull Hunter. In that chapter, Dan speculates that within 50 years, China will have completed a remarkable transition. Part of that transition is trading the enormous dollar reserves it has accumulated in U.S. trade for a global array of real assets. Turns out it may not take fifty years after all…

"In an article on Bloomberg today, William Pesek Jr asks, ‘Could GM, Microsoft End Up in Chinese Hands?’ This story picks up where The Bull Hunter ends," Mr. Denning tells us, "anticipating China’s strategy of spending dollar reserves on real assets, whether on raw commodities or industrial assets. Unaddressed is the fact that a revaluation of the Chinese currency would increase China’s purchasing power on international markets. Today, the target is UNOCAL. Tomorrow, why not GM?"

"In The Bull Hunter, I call China’s strategic desire for natural resources, global brands, and a short cut to international markets, combined with unprecedented access to cheap money from the country’s state-owned banks the ‘The Global Mineral Grab.’ China’s need for strategic resources is very bullish for certain sectors of the stock market. Which ones? Energy, obviously. But there are others. Food, uranium, coal, and even capital goods.

"I’ve outlined several industrial businesses in the final chapters of my book. They are what you might call ‘old economy industrial dinosaurs.’ But they have real value. The Chinese already know this. ‘The century-old Ingersoll Productions Systems, an Illinois-based maker of systems for building automotive power trains, was bought three years ago by Dalian Machine Tool, China’s largest tool maker,’ says the FT.

"In The Bull Hunter, my emphasis is not merely on deciphering China’s economic Grand Strategy. That seems pretty clear. My focus is how investors might profit from the global resource grab. In a nutshell: capital goods, resources, and energy – especially electricity."

*** Re-enacting famous battles has become a hobby for many people. Here in England, the Battle of Northampton was restaged this past weekend. The fight was between the Yorkists and the Lancastrians, in what is known as the "War of the Roses."

Poor Kieron Robb. One of the re-enactors was struck in the head by a sword and now lies in critical condition in a local hospital. As far as we know, he is the first casualty of battle re-enacting and the last casualty of the 1460 Battle of Northampton.