A "Water Torture" Bear Market, Part II

In a land where NASCAR is king, 10,000 B.C. opened No. 1 at the box office, and where three years into an economic recovery the Fed funds rate is still at 1%, what else is left to surprise us? Dr. Marc Faber explores…

A recurring theme of recent issues of this report has been that asset markets will remain extremely volatile. There is a tug-of-war between U.S. economic policy makers – notably, the Fed – who wish to support asset markets in order to stimulate consumption, and the private sector, which is tightening lending standards and bringing about slower credit growth and an economic downturn. The outcome of these opposing forces – both very powerful – will not be known for some time; hence the increased volatility.

In fact, I hesitate to make any forecast because I am faced with the following dilemma: Yes, as Ed Yardeni argues, we are in a recession; and yes, as Ian Scott of Lehman Brothers thinks, corporate profits could conceivably decline by as much as 45% if the United States were to slip into recession. But equally, as these economists and strategists argue, the stock market could move up despite poor economic growth and declining corporate profits. This scenario is particularly likely if the Fed pushes the Fed fund rate towards zero and if "extraordinary" monetary measures are implemented with increasing intensity – and also by non-U.S. central banks, which is now increasingly likely.

After all, anything is possible in a land of plenty (at least of dollars, deficits, and unfunded liabilities) in a country where one out of every 100 adults is behind bars (a total of 2.32 million); where the fear of its legal system is such that – according to a survey of 180 in-house counsel working in five European countries – lawyers working for European businesses would prefer to face a major dispute in Russia or China than in the U.S.; where stock car auto racing is the most popular spectator sport (the National Association for Stock Car Auto Racing holds 17 of the top 20 attended sporting events in the United States); where the movie 10,000 BC, described by critics as a "bombastic bore" and "sublimely dunderheaded", opened in early March at No. 1 with box office earnings of US$35.7 million, ahead of College Road Trip with US$14 million (to be fair, it was also No. 1 in Mexico); and where almost three years into an economic recovery (June 2004), the Fed fund rate was still at 1%!

Yet, I have my doubts about forecasts of the S&P 500 going above 1600 by year end, and of the Dow Jones being at between 18,000 and 20,000 within a year (see above) because, in my opinion, the credit cycle has turned down for good – and when this happens, all asset prices and the economy tend to perform poorly. It would also be extremely surprising if the financial problems that we are now confronted with, which have been fermenting for at least 15 years, were to be solved almost overnight by Mr. Bernanke & Co.! Equally, it would be the first time in my experience that the stock market had made a major low with so many commentators assuring us that a "low" is in place. Not to mention above-average valuations!

Lastly, if money moves out of money market funds into riskier asset markets such as equities, it is likely that interest rates will increase and contain a sharp stock market advance. I therefore maintain my very negative stance towards long-term Treasury bonds.

While I concede that sentiment data is very negative for the near term and so, from a contrary point of view, is supportive of an intermediate low, investors seem to be very complacent and far too optimistic about future corporate profits. A recent Merrill Lynch Fund Manager Survey found that 53% of U.S. fund managers thought a recession in the next 12 months to be "unlikely", up from 35% in February!

For now, I still think that a likely outcome is a "water torture" bear market à la 1973-1974, during which the downtrend was continuously interrupted by sharp countertrend rallies. A rally towards 1450 on the S&P is possible. In mid-March, commodities began to sell off sharply. This is an ominous sign, as it indicates either that the credit crisis is spilling over into asset classes other than equities or that global economic growth will disappoint, or a combination thereof. Last month, I suggested that some "preventive selling of industrial commodities, steel, and iron ore companies might be advisable".

I would like to reiterate here that in an environment of relative tightening of monetary conditions, commodities (including oil and art prices) should also correct meaningfully. This doesn’t change my long-term favourable view about the performance of commodities relative to U.S. financial assets. Should oil prices decline, the prime beneficiaries will be airlines. AMR, Thai International, Singapore Airlines, and Lufthansa could be bought for a short-term trade.

The trend over the past few years has been a relative underperformance of U.S. assets versus foreign stock markets – especially emerging stock markets, a weak U.S. dollar, and strongly rising prices for precious metals and other commodities. This broad trend could change for the intermediate term (three to six months). As indicated in last month’s report, U.S. equities have begun to outperform the MSCI World Index and I expect this outperformance to last for a few months. This doesn’t necessarily imply that U.S. equities will rise, but should they decline further then it will probably be by less than we would expect to see in foreign markets.

Gold remains my favourite asset class, but I wouldn’t rule out a decline in prices to below US$800 before the next upward leg gets under way. As Ron Griess observes, the gold price has tended to bounce off the 300-day moving average – currently at US$741. The U.S. dollar may have reached a selling climax in mid-March and I expect a rally, which may have some legs as dollar shorts will be quick to cover their positions.


Dr. Marc Faber
for The Daily Reckoning
April 17, 2008

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.

Shocking news today…Americans get poorer!

Yesterday, the Dow staged a big comeback – up 256 points. Gold rose $16 too – to $948. And oil hit a new record – just shy of $115. Then, it went over $115 in overnight trading.

So everyone is happy – except those who are short. The goldbugs are happy because gold is headed back to $1,000. Wall Street is happy because stocks are going up. The oil industry is happy…and so are the people who make ethanol…and the people who make hybrid, fuel-efficient cars.

And here at The Daily Reckoning headquarters, in the building with the golden balls, we’re happy too. But we’re happy for no particular reason. As near as we can tell, things are working out just fine – God is in His heaven; the Queen is on her throne; and investors are getting what’s coming to them.

We held our own Council of Nicea last night…about 3AM…after much meditation and drinking. And we came up with a creed. This is the way we think things are now:

I. We believe the Great Moderation is over. It has given way to a period of volatility…a period of Great Flation – of two sorts, both Inflation and Deflation, sometimes warring with each other…sometimes joining forces…sometimes not sure which way they’re going or what they are doing. Deflation, as we all know, is the work of the devil. But inflation is the work, primarily, of America’s own central bank. According to the shadow statistics on the subject (the Treasury no longer reports the numbers), the broadest measure of U.S. money supply, M3, is rising at nearly 20% per year. If output were steady, it should mean price increases of 20% per year too. Maybe more.

So far that hasn’t happened – except in some key areas, which we’ll come to in a minute.

II. We believe that Deflation is doing its work on yesterday’s bubbles – primarily the financial industry and U.S. residential housing. Inflation, on the other hand, focuses on tomorrow’s bubbles – in resources, soft commodities, precious metals and oil.

As for deflation, we see it working on the housing industry, where housing starts are at their lowest level in 17 years…driving consumer confidence down to its lowest level since 1993. The Fed’s Beige Book confirmed that recession was either on the way or already here.

Forbes reports that the worst markets are Miami, Denver, Baltimore and Chicago. We don’t know much about the other places, but until this last bubble, Baltimore property prices had been going down for 80 years. Now, they seem to be back on trend.

The Los Angeles Times adds that prices are being depressed by foreclosed properties – which are dumped back on the market. USA Today says the situation is going to get worse before it gets better. And bankruptcy filings – caused largely by falling house prices – rose 37% last year.

We have little new information from the financial sector – except that Merrill Lynch (NYSE:MER) wrote down another $6-$8 billion. There is also the note in today’s news that John Paulson may have made more money than any human being has ever made – taking home $3.7 billion, thanks to the generous and simpleminded investors in his hedge fund. Paulson bet big that subprime loans would go down. He was right. Now, he’s the Alpha male of Wall Street.

Of course, the whole thing is a terrific fraud, on almost every level. Maybe he took only "2 and 20" of his clients’ money last year. A lucky bet makes the managers rich…but eventually, the clients will go broke. More below…

We’re suspicious of numbers anyway. They mumble. They equivocate. They lie. Mr. Paulson may be the most miserable human being alive, for all we know. Yet, the world is focused on numbers…and on money…and we earn our living writing about it. But what do we really know? What do the numbers really tell us? We can’t really know anything important about Paulson; all we have to look at is the twisted figures.

As for inflation…yesterday, we saw not only a new all-time high for the price of oil…but all commodities are near record highs. Gold has gone up 37% in the last 12 months. Copper – thought to be a measure of economic health – is near its high. In Europe, consumer price inflation is rising at its fastest pace in 16 years.

III. We believe that the combined effect of these flations will be to lower the net worth of the United States of America. Its credits and its debits will be marked down by them both. Most important, the value of its labor will be reduced…so that Americans will be better able to pay their debts and compete (given their skills and capital formation) on the world market. (Keep reading…the figures are shocking…)

IV. And we believe that this is the way capitalism is s’posed to work – people get neither what they want nor what they expect, but what they deserve. Americans have been on top of the world for more than half a century. They have gotten ahead of themselves…they’ve challenged the gods. They have tried to do things that mortals cannot do – live beyond their means and remake the rest of the world in their own image…on borrowed money, no less. They need to be taken down a peg.

But wait, you’re probably wondering…how come Americans can’t stay on top of the world for another 50 years? Well, no law says they can’t. And maybe they will…but not before they’ve been whacked hard enough to make them change their ways. If they’re going to continue spending money at the present rate, they need to figure out some way to get more of it. Almost certainly, they will have to cut back instead. But that’s what this trend is all about – cutting back Americans’ wages, debts and spending power. And they hardly notice!

All those trillions of dollars they sent overseas represent claims on the U.S. economy…on its wealth…on its treasure…on its resources and productive capacity. But every day that the dollar goes down, those dollars buy less. Meaning, Americans’ debts go down.

Of course, their earnings go down too. Since the end of the 19th century, Americans have earned more than any other group. But at today’s dollar/euro (EUR) exchange rate, many nations are already much richer than Americans. The average American earned about $38,000 last year. But the average person in Switzerland earned $64,000. In Denmark, the average salary was $62,000. In Norway, Luxembourg and Germany all had average salaries around $60,000. The Belgians earned an average of $47,000. And the French…yes, dear reader…the frogs are now richer than Americans. The average Frenchman earns $42,000 per year. How’s that for divine comedy? How’s that for taking the starch out of the flag? In the measure that really counts – money – the French are ahead of Americans by a substantial margin.

Oh la la…

Still, we are happy here at the building with the golden balls…and we end on an optimistic, uplifting note: Rome reinvented itself several times – and managed to stay on top of the ancient world for at least five centuries. But each renaissance was a bloody affair – marked by civil war, revolution, slave uprising, barbarian invasion, bankruptcy and inflation. Augustus took power after defeating Mark Antony and Cleopatra at the battle of Actium. Then, he had his cousin (Ceasar’s son by Cleopatra) executed and solidified his control by murdering 100 Senators.

We know this will sound attractive to many readers.

*** The latest news tells us that New York’s economy is being helped by a massive influx of tourists from Europe. The Big Apple may seem expensive to most Americans…but to Europeans, it has become a lot cheaper.

*** Finally, the mainstream financial press is finally catching on to hedge funds; they’re a rip-off. This from Forbes:

"At first glance, hedge funds appear to load management contracts with incentives to encourage good performance and to keep managers’ interests in line with investors’. But in practice there is no way to encourage excellence without making scamming profitable as well…

"According to Foster and Young, investing in a hedge fund is like buying a ‘lemon’ – a car with hidden flaws. ‘This is a potential "lemons" market in which lemons can be manufactured at will, and the lemons look good for a long time before their true nature is revealed.’

"While numbers are imprecise because reporting is light, there are more than 10,000 hedge funds today controlling about $1.9 trillion in assets, compared with more than 8,000 mutual funds with $11.7 trillion in assets.

"The typical actively managed stock-owning mutual fund charges annual fees of about 1.3% of the investor’s holdings, while many passively managed index-style mutual funds charge 0.2% or less. Compared with this, hedge fund fees are very high, at 1% to 2% of assets and 20% of profits.

"If the market returned 8%, a mutual fund matching it would return 6.7% to 7.8% after fees were paid. A hedge fund with the same results would return 4.4% to 5.4% after fees.

"To offset these charges, hedge funds need dramatic results, but research indicates they have not been able to deliver over the long term. A 2007 study of 300 hedge funds by two University of Texas finance professors, John M. Griffin and Jin Xu, found that, from 1980 through 2004, hedge funds outperformed mutual funds by 1.4 percentage points a year. But that was before fees were taken into account. Moreover, the average was driven up by the tech-stock bubble of 1999 and 2000; otherwise, hedge funds did no better than mutual funds.

"In [a] hypothetical example, a fund manager named Oz sets up a $100 million hedge fund with the goal of earning 10 percentage points a year above the 4% annual yield of one-year government bonds. The fund will run for five years and charge a management fee of 2% of assets and an incentive fee of 20% of any profits that exceed the bond yield.

"Oz creates and sells a series of ‘covered calls’ and sells them for $11 million. Each call is a stock option that will pay the investor who bought it $1 million if the stock market rises by a given percentage. Using historical information, Oz figures there is only a 10% probability the market will rise that much. If it does, the hedge fund will be virtually wiped out by being forced to pay $111 million to the call owners. If it does not, the fund will pay nothing – and the $11 million received from the call buyers will be profit.

"Oz now has $100 million received from his investors, plus $11 million from the options sales. He invests the $111 million in risk-free U.S. Treasury bills earning 4%. After a year, the fund thus grows to $115.5 million. To his investors, this is a 15.5% return on their original $100 million.

"Oz earns his 2% management fee on the $115.5 million, plus 20% of the return exceeding what came from the 4% Treasury yield – or 20% of $11.5 million.

"There’s a 59% chance this process can continue for five years without a market downturn annihilating the fund, allowing Oz to collect $19 million in fees, as compounding makes the fund grow larger and larger. If the market does crash, Oz can close the fund, leaving the investors with devastating losses but keeping the fees he’s been paid to that point.

"This simplified ‘piggy-back strategy’ involves no borrowing, or leverage. A real-world manager could inflate his incentive fee by borrowing money to increase the size of his bets, though that would deepen the investors’ losses if things went wrong.

"The bottom line is that Oz’s investors, who don’t know what he is doing, may well believe his market-beating results come from brilliant stock picking or other wizardry. In fact, anyone could set up this simple strategy. Moreover, the investors are in the dark about the risks they are taking. They might well assume that if they make in excess of 15% one year, they might lose 15% in another. In fact, there’s a 10% chance they will lose more than 95% of the money they put in."

Until tomorrow,

Bill Bonner
The Daily Reckoning

The Daily Reckoning