An Eventual Inevitable Crisis

When we last saw Dr. Marc Faber, he was sitting on Barron’s roundtable, the bi-annual gathering of the world’s top investment minds. Today, he tells us where to put our money…

Whereas the bulls are convinced that the market will rise strongly for the rest of the year on the back of what they perceive to be "great economic news", the bears feel that the market is on the edge of a collapse.

There is a third possibility, which would be particularly unfavorable for the hedge fund industry. The markets could enter a long and tedious trading range. I am leaning towards the view that, for most markets, including developed and emerging stock markets, as well as for bonds and commodities, we saw the highs for this year in the January to March period.

From here on, I think that additional gains will be minimal and that the rewards will not compare favorably to the eventual downside risk. But, as was the case in Asia where most markets peaked out between 1990 and 1994, and were then followed by a trading range with a downward bias until the real collapse occurred in 1997/98 (a full seven years after most markets had topped out, and the final collapse manifesting itself in a devastating asset and currency slump), it is also possible that U.S. asset prices (homes and stocks) can continue to hold on to their gains for some time. It’s even possible that they make marginal new highs given the monetary conditions currently in place and the willingness of the U.S. monetary authorities to take extraordinary measures to prevent asset deflation from spreading.

Investment Diversification: The Final Battle

Still, I believe that, as John MacKay stated, "legislators are as powerless to abrogate moral and economic laws as they are to abrogate physical laws". Therefore, I am convinced that only a very serious crisis can correct some of the blatant imbalances that our global economic system has created. In other words, what we are dealing with at present is a battle between the economic policymakers and the "market." Guess which side I would bet on in the final battle!

So, at the very least, investors should gradually take out some insurance against what, in my opinion, is an eventual inevitable crisis, by being well diversified in every aspect of the investment universe.

The reason I am advocating diversification is that when quoting Leo Tolstoy’s description of the situation in Moscow when Napoleon reached the outskirts of the city, both inflationists and deflationists were right at the same time. Naturally, I am leaning towards an overweight position in hard assets over paper money and financial assets, knowing full well that, in a crisis, hard assets might also decline in value (except possibly for gold and other precious metals), but likely less so than financial assets.

Being diversified in terms of the "investment universe" also means holding assets in different jurisdictions. I have repeatedly advised our American readers to hold accounts outside the U.S. I am well aware that this has become increasingly difficult, and, under pressure from the U.S. authorities, some Swiss banks are extremely reluctant to accept such accounts. (If they do accept such accounts, they must not give U.S. residents advice by telephone, fax or e-mail; therefore, almost full discretion or periodic visits may be advisable.)

Investment Diversification: Foreign Exchange Controls

Singapore is, however, a viable and safe alternative to Switzerland. Still, the fact that the U.S. authorities have made the opening of overseas accounts so difficult should serve as a warning signal of things to come – that is, foreign exchange controls.

In terms of financial assets, I would overweight Asian equities, due to their lower valuations when compared to U.S. equities and the relatively favorable macroeconomic conditions in Asia (current account surpluses and undervalued currencies).

But, as I have pointed out before, whereas Asia may eventually de-couple economically from the U.S. business cycle, there is still a very close financial connectivity in place, with the result that at present the Asian markets track the movement of the S&P rather closely. Moreover, the overheated Chinese economy will have to slow down considerably at some point and could lead to some disappointments among the perennially bullish Asian investors.

In terms of commodities, I would be careful about buying markets where there are large speculative positions outstanding. In a recent issue of the outstanding Global Equity Strategist report, James Montien of Dresdner Kleinwort Wasserstein argues that "despite the talk of unwinding of the global reflation trade, we have only seen the tip of the iceberg", and that "outstanding positions and leverage remain enormous." Montien warns that, "when these trades finally snap, the devastation is unlikely to go unnoticed", and that "oil looks like it might become the next ‘China’". I concur with James Montien’s views and I am now also concerned that, despite long-term favorable fundamentals, the oil market could, in the near term, sell- off quite badly.

The only commodities I still like are coffee, which has recently broken out on the upside, sugar and orange juice, which is extremely depressed. In particular, sugar and orange juice would seem to offer a favorable ratio between potential returns and risks.

Finally, every investor should consider that, the longer the monetary- and credit-driven speculative party lasts, the worse the eventual outcome will have to be. So, the higher the markets soar and the more speculative they become, the more precautions will be advisable.

Regards,

Marc Faber
for The Daily Reckoning
July 14, 2004

Editor’s note: Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report. Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has specialized in Asian markets and advised major clients seeking down-and-out bargains with deep hidden value, unknown to the average investing public.

Tom Dyson, from the ‘Big Smoke’…

– The lesser of your two evil Baltimore-based editors finds himself back in London, his hometown. London hasn’t changed much in the last four months, but your editor has.

– He no longer enjoys commuting to work in packed trains that look so old they might have gone out of style in the ’60s. He no longer enjoys the surly big-city cynicism that Londoners always wear on their sleeves. And above all, your editor no longer enjoys paying through the nose for the privilege of grinding out an existence. In London, everything is a struggle.

– Maybe it’s because your editor has a new love, a love of the smell of fresh trash, intimidating urban streets, and of derelict factories…a love you only find in Baltimore, and maybe Pittsburgh, and perhaps Newark or Trenton too. Joking aside, Baltimore is a great city in a great country, and for the next three weeks, we will miss her dearly.

– But enough of the sentimental musings. We need to get back to musing about sentiment. Undoubtedly the most important sentiment to gauge is that driving inflation. It’s not a new debate; in fact, the inflation/deflation debate has already been flogged to a point beyond death and well into a state of reincarnation. So now we flog it some more…

– The U.S. financial system is acutely vulnerable to an increase in the expected level of short-term interest rates, we think. This vulnerability is a specific consequence of the carry trade, explains Steve Saville in his latest issue of the Speculative Investor. "The closing out of carry trades earlier this year in response to a modest increase in short-term U.S. interest rates relative to short-term euro interest rates precipitated some sharp moves in the financial markets," he points out. "However, we suspect that many of these trades remain in place and that the market action over the past 6 weeks has encouraged the leveraged speculating community to initiate new carry trades…"

– Unwinding these carry trades puts upward pressure on the dollar as traders cover their short-term borrowings. Hence the strong dollar-rally in April and May, which took the euro from $1.29 to $1.17. "[Once] the dollar starts to rally," continues Saville, "it should set a self- reinforcing trend in motion because a stronger dollar results in reduced inflation expectations and, therefore, higher REAL interest rates and a narrower yield-spread. The increase in the real interest rate and the contraction in the yield-spread, in turn, help boost the dollar."

– Keeping the carry-trade dynamic in mind, if one could only predict inflation expectations – and thus the trend in short-term interest rates – the rest of the markets ought to fall neatly into step.

– In this upside down world, if inflation fears increase, further unwinding the carry trade, we should see bonds and gold sell off while the dollar rallies. Conversely, if deflation starts to gain traction in the media, expect the opposite. But which is it?

– Well, yesterday at least, the dollar was strong. It gained almost a cent against the euro on news that May’s trade deficit was only $46 billion, $2.3 billion better than had been expected. By day’s end, the euro bought $1.2314. Gold didn’t fancy the news much, and fell $6.20 to $402.

– On Wall Street, the markets were flat. The Dow added 9 points to 10,248, while the Nasdaq lost 5 points to 1,932. The S&P gained, by less than 1 point, to 1,115. Ten-year yields rose 3.6 basis points to 4.48%.

– Regular readers will be only too aware that your humble editors rarely have the audacity to crawl out onto the plank…the shark-infested waters below don’t look too appealing from our comfortable perch here at the Daily Reckoning, whether it’s in Baltimore, London or Paris. But today, we feel like a punt…today, we feel like predicting a continuation of the dollar’s rally.

– Naturally, we make this unusually bold statement thinking like short-term contrarian traders. Our long-term view is unflinching…the dollar’s value has been terminally impaired and what’s more, the Fed will continue to prescribe its EZ-credit poison for the foreseeable future. So what, then, is the substance behind our bias?

– Not very much, we answer to the discerning reader. Sentiment-driven trends, we have learned, tend to last longer than three months. Earlier this year, the shift in the press, the Fed and the economic data towards an inflationary bias was violent. The swing back to a deflationary bias will inevitably follow, but in your humble editor’s opinion, it is too soon.

– Besides, bullish sentiment towards the dollar dissipated very quickly after June’s disappointing payroll number. Your contrarian editor reads strength into this particular message.

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Bill Bonner, back in Boston…

*** Boston is an appealing city. But sometimes you forget that it is an American city. You walk down the streets and are as likely to hear Russian or Chinese spoken as English. It must be the universities that attract them. In turn, the foreigners push up real estate prices and make Boston a lively place.

*** Americans have a strange attitude towards immigrants. They are all descendants of immigrants themselves…and depend on new ones to fund their retirement programs and buy their houses at inflated prices. Still, they often resent the newcomers.

An email received this morning:

"If there were a national referendum on immigration, Americans would vote, overwhelmingly, to limit immigration, protect the borders – particularly the southern border – and deny citizenship rights to illegals…the American public would also vote to increase the INS budget to support these measures. "But such severe measures would not be necessary if Mexico privatized its mineral resources; entrepreneurs, business and capital would all be enticed to Mexico in the search for oil.

"The wealth that would accrue to Mexicans would be sufficient for them to want to remain in Mexico. "It seems we are trapped in ‘an odd-bedfellows’ situation with Democratic elites desiring immigration to swell their party’s voting ranks and GOP elites desiring immigration for the cheap labor it provides. "The next immigration crisis from the south is likely to come from Peru, Bolivia and Columbia and the rising Synarchist movement…inheritors of the Shining Path. "You might have heard it here first…"

*** And more travel notes from the ‘lost continent’…

"If an apartment building costs $1.8 million, and you knew you would have to spend 5% to cover costs – maintenance, taxes, management, etc. – and it had 4 units, how much would you have to rent each unit for in order to get a 5% net yield?"

We posed the question to our children after stopping for lunch at Stephi’s on Newbury St. We were exploring Boston. At least, we we’re supposed to be exploring Boston. Half the party seemed to think it was a shopping trip. We had already stopped into Gap, Ralph Lauren, and Express. We would visit many more retailers before the day was over. Boston has plenty of them.

You go in with children at your own risk. You find things you didn’t even know existed…and then you discover that you needed them.

"Twenty-nine dollars for a pair of flip-flops? You’ve got to be kidding," said Pater Familias.

"But they’re genuine leather," Sophia replied.

"Why does Edward need a new pair of shoes?"

"His old ones are worn through…and don’t start asking a lot of questions," Elizabeth continued. "Henry needs a pair of pants and a belt. And Jules needs a new pair of shoes too."

"They look fine to me."

"But Jules is going for his college visits; he needs to look better than he looked today."

"What’s wrong with the way I look now," Jules wanted to know, standing in front of us in a pair of worn blue jeans, gray t-shirt, with flip-flops on his feet (the $4.95 variety).

The nice thing about America, dear reader, is that it makes us feel good about ourselves. Half the population dresses like Jules. The other half glories in a sense of superiority, without actually doing anything other than putting on a decent shirt and a pair of shoes.

But most amazing about modern America is that it provides almost endless ways to spend money…without actually making any improvement in the way you live or dress. In Boston’s retails shops, we found not only expensive flip- flops and t-shirts, but designer jeans – already worn through and in need of patching.

"They must pay someone in Thailand to wear holes in them," we told the girls. "But why not just buy a new pair of jeans and wear them out yourself?"

"Oh Dad," they said together, as if the question did not merit a response. So we turned our attention back to Jules:

"How did your first visit to a temple of reason and higher learning go," we asked. Earlier, Jules and his mother had gone to visit Boston University.

"It wasn’t bad," said Jules. "This is not a bad town. I wouldn’t mind living here for a while. But Dad, guess how much the tuition and room and board are?"

"I don’t know…probably about the same as we paid at St. John’s…what was that…about $25,000 a year?"

"Guess again. It’s $38,000. "

"What? Now, you’ve got to be kidding. "

"No, that’s what it is. Seriously."

"What a rip-off. There’s no way it can possibly be worth $38,000 a year to send a kid to Boston University…even if they guaranteed a place at Harvard Medical School and a Nobel Prize."

"Oh shhhsssh…" said his better half. "Education is expensive. But a good education is worth it."

"Yeah…but paying $38,000 per year doesn’t give you a good education. It just opens the doors to beer parties and football games. You still have to read and think to learn anything. When you pay your money to a university, you’re paying for sports facilities and research installations and professor’s sabbaticals…and pensions for the maintenance staff…and pool chemicals. All of that stuff may be entertaining, but it’s only the reading and thinking that give you an education. And you can do that by walking into a public library for nothing."

"No you can not. Good professors and good curricula help guide you…they motivate you…and they help you understand how things fit together. Trying to get an education on your own is hopelessly difficult; that’s why people don’t do it."

"No it isn’t. They don’t do it because you don’t get a diploma from a public library. And they think that without a diploma you can’t get a good job. Which is all nonsense. Maybe the government cares about diplomas, but real businesses just want people who can think and take responsibility…and act. And everyone knows that most college graduates can’t think at all. And they don’t know anything. They can’t think or write because they’ve spent their college years drinking and getting up late and missing classes…and taking things like psychology and gender studies and environmental appreciation…where you don’t have to know anything. Which is a good thing, because the more of that claptrap you know the dumber you are.

"They would have been better off getting a job in the real world…where they might have learned something…and saved themselves $100,000."

"Look, Jules is getting ready to go to apply to college. It’s going to be hard enough for him to get into a good school without you undermining the whole process by telling him he’d be better off not going at all!"

"I’m not saying he would be better off. I don’t know. But I’ll bet that the average goof-ball student would be better off. Bob never went to college. And did very well. He became an accountant. And then went into publishing. He read. He thought. He wasn’t afraid of ideas. And he wasn’t the least bit impressed by college degrees.

"That’s the way it is in real life…or the way it ought to be. In the publishing business when someone comes in for a job, you don’t bother asking if he has a degree. You just want to know if he can do the job."

"But how do you know?"

"Well, you don’t. So you ask for a writing sample. If it’s good, he gets the job. If it’s not, he doesn’t. It doesn’t make any difference what school he went to…or what degrees he got. Of course, when you get a candidate who just graduated from Yale…you at least can presume the guy is smart, or he never would have been admitted. But then…on the other hand…look at George W. Bush."

"Bush must not be as dumb as he seems, or he never would have graduated from Yale and never would have been elected president."

"Maybe…I don’t know. But what I do know is that you don’t need a college education to be well educated…or to do things. And since most college educations are little more than further indoctrination in the latest silly ideas, a man probably has a bit of a head start if he doesn’t go."

"Oh…you’re really over-doing it now."

"No I’m not. Galileo didn’t go to Boston University or any other modern school of higher learning. Neither did Abraham Lincoln. Or H.L. Mencken. Or Napoleon Bonaparte. Or Henry Ford. Come to think of it, almost none of the great men of history ever went to anything like a modern university. Jesus Christ never set foot in a school, as far as we know. And Bill Gates is a college dropout. Alexander the Great was schooled for a few years by Aristotle, but even the greatest philosopher of his time probably didn’t charge $38,000 a year.

"It’s all part of the monumental fraud," we went on…revved up. "Nearly everybody goes to college now…and now we think we are so much smarter than those who went before us. But the average college graduate probably knows less than the average person who finished the 8th grade in the last century. It’s just another form of inflation. A dollar is worth about 5% of what it was back then. So is a college degree. We study sociology and the interpretation of dreams…and gender stereotypes and modern soap operas…and now we know a lot more about nothing…and a lot less about everything that matters."

"$3,750," said Henry.

"What…?"

"That’s how much you’d have to rent each apartment for in order to get a 5% return on your investment."

"Oh…well, see there…" Dad continued. "Apartments around here rent for only about $1,500 for a one-bedroom. If you buy that apartment building, you won’t even be able to cover your costs. Looks like the real estate bubble has reached Boston."

"That’s nothing," said a friend over a drink last night. "You should see what is happening in Miami. It’s nuts. I bought an apartment down on South Beach six years ago. I paid $360,000 for it. Now, the one above me just sold for $1.1 million.

"Now if you want to buy an apartment down there you have to put your name in a lottery. They sell them ‘pre- construction.’ They just put up a sign on an empty lot and people line up to buy the things. And the prices go up while you’re waiting in line to buy them. It’s insane."

"Yeah…it’s gotten crazy," said another Florida friend. "I bought a house in Delray Beach, not a great house, for $175,000…I guess it was about 8 years ago. A couple of years went by. I probably spent another $50,000 on it. And then I sold it for $395,000. I remember telling someone that ‘this has got to be the top of the market.’ Well, I saw that it sold again about 6 months ago for $899,000."

"And in Georgetown [an up-market section of Washington, DC], you remember that house I bought," the first friend recovered the floor. "Well, it’s been a royal pain in the [derriere] because I’ve had to deal with all the historical preservation boards and local committees…but I finally got permission to put on a second floor. I spent $2 million for the house…and I’ll spend another $2 million making it the way I want it. But listen to this, a guy came along just last week and offered me $7 million for it even before I do the renovations. Apparently, you just can’t find big houses like that – it’s on a half-acre lot in Georgetown.

"Well, I was thinking about selling it…even though it was supposed to be our dream home. But I talked to my real estate agent. He told me to stick with it. When I finish the work, he told me it will be worth $10 million. It’s nuts!"