A "Water Torture" Bear Market, Part I

In a market climate that is tumultuous at best, Marc Faber wonders what lies in wait for the global economy.

"The greatest difficulties lie where we are not looking for them!"

The above observation was penned by Johann Wolfgang von Goethe and may be very prescient in today’s economic and financial conditions.

Let us assume that the unthinkable happens: China’s economy slows down sharply, or even contracts – and there are reasons why it could. Commodity prices slump and bring about economic hardship in the resource-producing countries of the world. In turn, these countries’ imports of capital and consumer goods from Europe and Japan decline.

We would then have the perfect setting for a global economic contraction with dire consequences for corporate earnings and asset prices.

Now, I concede that this scenario is not very likely to occur. However, on a recent visit to Dubai, I could see how it might unfold. I have been traveling to the Middle East since 1977, and I experienced first hand the oil boom of the late 1970s and the collapse in equity and real estate prices when oil prices fell in the early 1980s. About three years ago, on a visit to the Middle East, I felt that the gigantic equity boom would come to an end.

In 2006, most of the Middle Eastern stock markets declined by 50% or more, though the economies didn’t suffer. Yet, over the last three years, it has seemed to me that there is something not quite right about the enormous construction and economic boom that Dubai and other Middle Eastern countries are experiencing. (The world’s tallest buildings are going up there….) What if oil prices were to decline? But why would oil prices decline? Obviously, oil prices would decline because of diminished demand for oil from China and other rapidly growing emerging economies.

But why would demand for oil from China slow down or decline? Obviously, because of an economic recession! The assumption that the Chinese and other emerging economies will continue to expand rapidly may prove to be very deceptive. In recent years, the US has experienced a credit boom and China has had a capital spending boom. Both could come to an end at about the same time! I also wish to stress that there is enormous connectivity between all the world’s economies and that it would be wrong to assume that the present financial crisis, whose epicentre is the United States, couldn’t be followed by financial and economic crises elsewhere.

Also, if the Dubai boom was an isolated event, I wouldn’t be particularly concerned. But everywhere I travel I am left with the uncomfortable feeling that the current boom is surreal and unsustainable. The INDABA – the annual conference for natural resources professionals – which I attended earlier this year in Cape Town, has become a huge circus reminiscent of the consumer electronic shows held in Las Vegas in the late 1990s.

And whereas I have a relatively positive view of commodities, I doubt that all these mining executives (predominantly promoters and liars) will make as much money as they hope to, simply because exploration and mining development costs are soaring. Every major city around the world is also experiencing a huge condo and office construction boom, and in resort areas there are enormous developments of secondary homes.

Should the financial sector contract, as I believe will occur for several years, will all these new offices find tenants? I also wonder if all the condo and second home buyers are aware of the maintenance costs of their units and that in over-supplied markets prices can decline sharply.

Lastly, I think that investors fail to appreciate fully the process of deleveraging after a period of accelerating credit growth. In a credit-driven economy, a deceleration of credit growth will depress all asset prices and tip the economy into recession. In this respect, I am particularly surprised that analysts still expect S&P 500 earnings per share to increase to above US$110 in 2009.

Over the past few months, I have discussed corporate profits a number of times and shared with my readers my concern that we are in the midst of an earnings bubble, which has been driven largely by an explosion of financial sector earnings.

Richard Berner, chief economist at Morgan Stanley, recently published an excellent study entitled "Downside Risk for Corporate Profits", in which he opines: "I think the earnings outlook will disappoint.

"The US economic outlook has darkened and fading operating leverage, dwindling pricing power, and deteriorating credit quality will squeeze margins. Despite the benefit of a weaker dollar, slower growth abroad seems likely to tame the overseas earnings boom" (Morgan Stanley Research North America, US Economics, March 17, 2008). In

Berner’s view, "the combination of slower growth and high operating and financial leverage in Corporate America made a contraction in earnings unavoidable even if the economy skirts recession". (He is referring here to the corporate earnings decline in the fourth quarter of 2007.) "Lower marginal but higher fixed costs have increased operating leverage. Corporate America’s ability to exploit that leverage propelled earnings to record levels when growth was healthy. Strong increments to revenue went straight to the bottom line…. But leverage – both operating and financial – works both ways. Slower growth means that operating leverage is working in reverse, with decreases in revenues going right to the bottom line."

Berner’s two principal concerns about US corporate profits relate to "operating leverage" and the fact that the "strength of overseas earnings" is about to be "challenged". Operating leverage is at present far higher than in the 1990s, which, according to Berner, could mean that "a deeper recession, especially one that spreads abroad, would promote a much more serious profit squeeze."

Berner shows that overseas earnings have increased from 15% of overall earnings 20 years ago to 31.5% at present, as "growth abroad – and the higher oil price that comes with it – are powerful engines for US earnings". I may add that a weak dollar is another extremely powerful driver of overseas earnings as a percentage of total earnings. Also, that "growth abroad – and the higher oil price that comes with it – are powerful engines for US earnings" supports my view about the extreme connectivity we now have between economies in the global economy.

According to Berner:

"[T]here’s also a darker side to earnings from abroad. I worry about the potential for a vicious circle in transatlantic earnings. The US earnings downturn is already spilling over into weaker earnings abroad, especially in Europe. NIPA data show that US earnings remitted abroad in last year’s third quarter declined by 7% from Q3 2006. No doubt such weakness was a factor in our European strategy team’s recent earnings downgrade; they expect a 16% plunge in European earnings this year compared with the consensus forecast of a 7% increase. The impact of the US earnings downturn on Europe likely will be significant: US direct investment data suggest that about 2/3 of our payments abroad go to Europe.

"Such payments, which are earnings of US affiliates of foreign companies, crashed in the last recession – from a peak of $66 billion in Q1 2000 to a loss of $24 billion in Q4 2001. And for European companies the strength of the euro is a massive headwind: A 13% appreciation of the euro has magnified the earnings downturn in euros for European companies’ US affiliates [as it has magnified US overseas earnings – ed. note). Together with tighter financial conditions, I’m concerned that weak earnings at European companies could contribute to a sharp deceleration in capital spending and in European growth. That would complete the circle, because it would also hurt US earnings abroad. About half of those overseas earnings originate in Europe."

I have pointed out above that there is now a much higher economic and financial connectivity in the world than has previously been the case. However, I have to confess that I hadn’t thought about, and fully appreciated, how weaker US growth, manifested as declining profits in the United States, would affect the affiliates of foreign companies, which in turn would lead to lower US overseas earnings. Richard Berner’s analysis is very perceptive! Also, I doubt that European stock markets have fully discounted the 16% plunge in 2008 European corporate earnings that Morgan Stanley has estimated!

Berner concludes his exposé of US corporate profits with the following – very politely phrased – remarks:

"Against this backdrop, what’s really perplexing is that Wall Street analysts don’t think that a weak 2008 will cast doubt on the vigor of next year’s results. On the contrary, in what I think is fundamentally flawed logic, they have maintained the level of their 2009 estimates where they were, so that downward revisions to 2008 earnings actually boost the 2009 growth rate. Street estimates for 2009 S&P 500 earnings growth have been revised up to 15.5% from 14.7% at the beginning of January. By comparison, we expect a 5.9% increase in 2009 after-tax economic profits that would leave the level below that in 2007."

As an aside, a friend of mine, a very savvy and keen observer of economic and financial trends who doesn’t mince his words, calls what the Street has done with 2009 S&P earnings estimates "criminally insane". I agree. After all, illusion is one of the most pervasive realities of life!


Marc Faber
for The Daily Reckoning
April 16, 2008

It’s becoming very clear with each passing day that the U.S. economy is headed for an iceberg… and over the next 12 months…and despite all the bank write-downs, market bombs and "bailout" talk already…there are at least five more devastating new financial shocks ahead.

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.

What a mess!

In England, as in America, consumers are caught between the hammer of inflation…

"Prices soar at the fastest rate for 17 years," says a Daily Express headline.

…And the anvil of deflation…

"House prices fall at fastest rate since 1978," proclaims the Guardian, with the BBC adding that U.K. housing gloom is "the worst in 30 years."

Meanwhile, over in the financial sector, the Globe and Mail says the financial industry in London "could lose 40,000 jobs."

But here at The Daily Reckoning headquarters in London – in the building with the golden balls on the roof, just over Blackfriars Bridge, famous as the spot where Italian banker Roberto Calvi hung himself – we can step back and take the long view.

Prices rise. Assets fall. But what really hurts this time is that the price of an hour of Anglo-Saxon labor (which is all most Americans and Englishmen really have) is going down. (More about that later in the week…)

Do Americans care what happens to the Brits? Not particularly. Unfortunately, the two countries are both in the same boat…both had been sailing along so happily in the sloop: the "Anglo-Saxon" Economic Model. Now, they’re taking on water. It’s all hands on the pumps!

That is to say, both Americans and Brits borrowed too heavily. Now, the time has come to pay back…and no one is very happy about it.

Foreclosures in the United States were up in March, as expected. Bloomberg tells us they rose 57% "as homeowners walk away."

They’re sure not driving away…they can’t afford to!

Oil hit a new record yesterday. At $114 it has never been more expensive. This is another way of saying that Americans and Englishmen have to work longer to buy a gallon. Gasoline is about $2.88 in New York. In old York, it is more like $10 a gallon.

"We’re not producing enough oil," says Gordon Brown, Britain’s CEO.

In fact, we’re producing more than ever before. We’re producing so much…we may never again be able to produce so much. And still the price is rising.

"Russian oil production is peaking," says our man on the case, Byron King. His source is the Financial Times, reporting:

"Russian oil production has peaked and may never return to current levels, one of the country’s top energy executives has warned, fuelling concerns that the world’s biggest oil producers cannot keep up with rampant Asian demand.

"Leonid Fedun, the 52-year-old vice-president of Lukoil, Russia’s largest independent oil company, told the Financial Times he believed last year’s Russian oil production of about 10m barrels a day was the highest he would see ‘in his lifetime’. Russia is the world’s second biggest oil producer."

Bryon elaborates: "He wears the Red Star, I suppose. So you can trust him, right?"

"Most of the Western Siberia oil fields were discovered in the 1950s, 1960s and 1970s. Those fields are now in terminal, irreversible decline even with all the able assistance of the likes of Schlumberger and Baker Hughes. So maybe there was another reason that Putin stepped down as President? There are no coincidences, comrade. Old Russian saying goes, ‘Quit while you are ahead.’

"The genius behind much of USSR oil production was Nikolai Baibakov, who just died on March 31 at age 97. His post-WWII leadership of the Soviet oil industry led to discoveries that fueled the USSR, and later Russian Federation.

"Sic semper petroleos Russkoye."

But let’s not get distracted. So what if oil output is falling?

Ah, dear reader, you’re torturing us with questions like that.

Don’t you know that the whole machinery of Western industrial civilization depends on cheap oil? And don’t you know that we now have to compete for every drop – with the communist Chinese, for example. Yes, their demand for the black goo is rising nearly 5% per year. And now that we’re not actually producing more and more each year, this extra demand…combined with monetary inflation…works on the price like a booster rocket – sending it into orbit.

But is this cycle over? Has the price of oil – which has gone from under $40 in 2001 to over $100 in 2008 – run its course? Is the bull market over?

*** "It doesn’t look like the party is over just yet," says colleague Chris Mayer. "Since January 2001, you can explain the move in the price of oil largely as a function of the increasing money supply. As the amount of money grows, the price of oil rises. In fact, almost 87% of the move in the price of oil can be explained by the increase in money supply…."

As we’ve been saying – and we aren’t the first – inflation is a monetary phenomenon. Inflation that pushed the price or rice to another record high yesterday…and sent gold back up over $930.

But what does this imply about the price of oil going forward?

"Given that we are still in the midst of a credit crisis of sort, is seems unlikely the Fed will tighten money in any way at all," Chris continues. "That leaves a clear path for the price of oil and commodities to continue to rally in nominal terms…"

Chris goes on to point out that oil is no longer merely a U.S. story. The rest of the world is uses more and more of it too. As a nation gets richer…its people use more and more oil…until it reaches a peak …and then oil consumption levels off. That’s why people in Britain drive Skodas instead of Chevrolets. They have reached a level of energy maturity…in which per capital consumption tends to stagnate below 20 barrels per person per year. U.S. energy consumption has leveled off at 25 barrels per person. Hong Kong, South Korea and Japan all have leveled off at about 15 barrels per person.

But China and India – the world’s two largest countries – "are only beginning to consume oil at any meaningful level," Chris notes. They’ve got a long way to go – with huge jumps in the quantity of oil used – before they get anywhere near the levels of the developed world.

"The price of oil has room to run yet," Chris concludes, "in part because of the growth in money supply and in part because of pressing international demand. Second, even if we already saw oil production peak, history says that prices won’t retreat by much over the next several years. And finally, the capital spending boom by the big oil companies is just getting started, which is great news for investors in oil field services companies."

*** Of course, increases in money supply don’t affect ONLY the oil industry. We mentioned rice – which hit a new record yesterday, too.

If gold goes up in price, hardly anyone cares or notices. Oil, too, is something most people can live without. But food?

All over the world, food prices are causing havoc. Riots have broken out in Haiti, Indonesia, the Philippines, and Cameroon – because basic food staples…rice, wheat, corn, soybeans…have become so expensive.

Why are food prices high?

Normal agricultural cycles, is one reason we gave yesterday.

Another is the increasing worldwide demand.

Here’s a third reason – biofuels. On Monday, Britain passed a law requiring that 2% of fuel come from plants (actually, all of it is believed to come from plants…but oil, gas and coal have had millions of years to compress and ferment.) Since Britain doesn’t produce enough biofuel to meet the quota…she actually has to import the stuff on ships from America. Not only does it take more energy to produce the fuel than it generates…the Brits add the cost of shipping it across the Atlantic. But as we keep saying, there’s no problem so awful that politicians can find a way to make worse.

Until tomorrow,

Bill Bonner
The Daily Reckoning

The Daily Reckoning