Investment Hocus Pocus
The Daily Reckoning PRESENTS: While documenting the chronology of previous investment booms is, to most people, boring, Marc Faber feels that it is nevertheless necessary to recognize the differences between previous investment booms and today’s unique investment environment. Read on…
INVESTMENT HOCUS POCUS
The feature most common to previous investment booms was that a bull market in one asset class was accompanied by a bear market in another important asset class. Precious metals soared in the 1970s, but bonds collapsed. Equities and bonds rose in the 1980s, but commodities tumbled.
In the 1990s, we had rolling bubbles in the emerging markets, but Japanese and Taiwanese equities were in bear markets while commodities continued to perform poorly. Finally, the last phase of the global high-tech mania (1995-2000) was accompanied by a collapse of the Asian stock markets and Russia, as well as a continuation of the Japanese and commodities bear markets. By the late 1990s, most emerging markets (certainly in Asia) were far lower than they had been between 1990 and 1994. In the 1990s, emerging markets grossly underperformed the US stock market
Currently, looking at the five most important asset classes – real estate, equities, bonds, commodities, and art (including collectibles) – I am not aware of any asset class that has declined in value since 2002! Admittedly, some assets have performed better than others, but in general every sort of asset has risen in price, and this is true everywhere in the world.
In the early phases of all previous investment booms, investors failed to recognize that the “rules of the game” had changed and continued to play the asset class that had been the leader in the previous investment mania. In the 1980s, every increase in gold and silver prices was perceived to be the beginning of a new bull market in precious metals (after silver prices collapsed in January 1980, prices doubled three times between 1980 and 1990 – all within a downtrend), while investors maintained a very skeptical view of bonds. In the early 1990s, investors failed to recognize the emergence of a high-tech sector uptrend, although, as explained above, high-tech stocks were already performing extremely well between 1990 and 1995. Global investors continued to believe in the merits of Asian stocks right to the end and actually stepped up their buying in early 1997!
Similarly, in the current asset inflation, investors have continued to focus on the high-tech bull market and have largely missed out on the huge increase in price of commodities, and of Indian, Latin American, and Russian equities. At the end of each investment mania, investors believed in some sort of “excess liquidity” that would drive the object of the speculation forever higher.
At the end of the 1970s, the “excess liquidity” related to the OPEC surpluses; at the end of the Japanese stock and real estate bull markets, “excess liquidity” centered around the enormous Japanese current account surpluses; during the 1990s emerging markets mania, “excess liquidity” was perceived to come from foreign buying and the Yen carry trade; and at the end of the high-tech boom the investment community believed that “excess liquidity” would come from record mergers and acquisitions, a reallocation of funds from bonds to equities, and easy monetary policies by the Fed (a belief that was fostered by the Mexican and LTCM bailouts and money printing ahead of Y2K).
But as Albert Edwards so eloquently explained in a recent scathing report entitled “Lies, rhubarb, poppycock, bilge, utter nonsense, caravans and liquidity” (see Dresdner Kleinwort Global Strategy Report, January 16, 2007), “liquidity is the hocus pocus of the investment world. It means totally different things to different people but is often cited as being a major driver for buoyant markets”.
Most presciently, Edwards explains that with respect to investment manias, “when markets are rallying but seem expensive, when new issues fly out of the door and when fundamental analysis often appears to fail to explain events, the safe haven for the market commentator is often to rely on the explanation that there is lots of liquidity”. I urge our readers never to forget these words!
What is peculiar to the current investment environment is that liquidity is supposed to come from not just one or two sources, but from everywhere! From OPEC surpluses, from the US Fed and other central banks, from the Asian current account surpluses (excess savings), from the Yen and Swiss Franc carry trade, from the large size of money market funds and bank deposits, from rising asset prices, leverage, and a tidal wave of private equity funds, and from artificially low interest rates. It’s no wonder that, given such beliefs, asset markets are all flying to the moon!
In all the previous investment booms we discussed, the bull market was interrupted by severe corrections. Gold corrected by more than 40% between December 1974 and August 1976, equity markets corrected violently in 1987 (Taiwan and Hong Kong dropped by 50%), and bonds corrected sharply in 1983-1984, in 1986-1987, and in 1994. In the high-tech mania, technology stocks corrected sharply in 1995-1996 and in
1998. Between its 1997 high and its 1998 low, the Russian stock market gave back almost all its previous gains
In the current asset bull markets, we have, with very few exceptions (copper, zinc, oil, and sugar), not had a concerted and strenuous correction phase à la 1987 and 1998 (and certainly not in US equities). As the advance in previous investment manias matured, its leadership tended to narrow considerably. At the end of the 1970s’ commodities bull market, only oil, copper, precious metals, and energy and mining shares were still rising. In Japan, most of the listed equities peaked out in 1987-1988, but financial stocks, including insurance companies, banks, and brokers, drove the index up until the end of 1989. In the rolling emerging market bubbles of the 1990s, most markets peaked out between 1990 and 1994 but some markets such as Hong Kong still managed to make a final high in 1997. In the TMT boom, the advance became extremely concentrated after
1999, with many tech issues only making marginal new highs in March 2000 or failing to better their 1999 peak prices.
In the current asset boom, we haven’t yet seen any significant narrowing of the asset markets’ advance (although Middle Eastern markets tumbled last year). Aside from a few commodities and US home prices and housing-related stocks, most asset prices are still rising, although admittedly with varying intensity.
A feature common to all great asset booms is that they were born from either an extremely low valuation in real terms, an extended base-building period, or from a lengthy and pronounced underperformance compared to other asset markets. In 1970, the gold price was no higher than in 1933, and down in real terms by 70% from its 1897 high. The Japanese asset boom, which had in fact begun back in the 1960s, led to the entire Japanese stock market having a stock market capitalization in 1970 lower than that of IBM. In other words, in 1970, Japanese equities were very inexpensive compared to the US stock market. In 1982, US stocks had declined by more than 70% in real terms from their 1966 highs. And although, at the time, US equities were, adjusted for inflation, no higher than they had been in 1899, to be fair their total real return (including dividends) was far higher.
Still, by 1982, including reinvested dividends, US equities were no higher than in 1961. Also extremely depressed were US bond prices, with bond yields at their highest level in the 200-year history of the US capital market. Taiwanese and Korean equities in 1984 were at about the same level they had been in the early 1970s and, adjusted for inflation, dirt-cheap. In the late 1980s, Latin American stock markets were, in US dollar terms, no higher than they had been in the late 1970s and far lower than in the early 1970s and early 1980s.
In 1990, US high-tech stocks were selling for about the same prices they had reached at their 1973 peak and for around ten times earnings. Compared to the valuation of the Japanese stock market in 1990, US high-tech stocks were then extremely depressed.
The 2002 asset price increase in all asset classes also included some asset classes that started to rally from extremely low inflation-adjusted prices or low valuations compared to some other asset prices. Particularly low inflation-adjusted prices were evident for commodities (which bottomed out between 1999 and 2001). And whereas the Nikkei had massively underperformed US and European equities in the 1990s, and was therefore relatively inexpensive compared to these markets, emerging markets had both underperformed US assets since 1990 and were, adjusted for inflation, very depressed.
However, not depressed (adjusted for inflation) or compared to other asset prices, were US equities. Moreover, following their 20-year bull market, US bonds – and especially Japanese bonds – were by no means depressed! Every epic investment boom lifted prices far higher than anyone could have imagined (although I concede that in the mid-1990s, Richard Strong told me that if Japanese stocks could sell for 70 times earnings in 1989, US equities could also sell in future for 50 times earnings). In 1970, no one dreamt that precious metals would increase by more than 20-fold. In the early 1980s, it would have been considered heresy to forecast that the Dow Jones would double and bond yields would decline to less than 4%! And investors certainly didn’t expect the
Japanese stock market, which had already quadrupled in the 1970s, to rise by almost another six-fold between its low in 1982 and its high of 1989. In the late 1980s, few people expected the Latin American markets would ever recover; and in the early 1990s, no one (including myself) expected US high-tech stocks to become the best performing asset class in the 1990s.
Since the current asset price increases got under way in 2002 – and contrary to the expectations of some of the perma-bulls on US equities – commodities, and emerging stock markets and economies, in which, fortunately, platform companies are largely absent, have performed substantially better than US asset prices. Since 2000, the Dow Jones has lost more than 50% of its value against gold and much more against industrial commodity prices. Moreover, since 2002, the Argentine and Russian stock markets, whose economies are perceived as “knowledge absent” when compared to the great “knowledge-based” American economy, are up ten-fold or more!
Now, I will concede that the current “asset inflation” (a pompous and potentially dangerous notion, to quote my friends at GaveKal Research) may be far from over and that the end game in the current asset price increases is far from predictable, but, based on the experience of the previous four investment booms, it is likely that the significant diverging trends in the relative performance of asset classes (underperformance of US assets) will persist for far longer than is now expected.
Another common feature of the last stage of every asset boom was high trading volume, widespread public participation, high leverage, and money inflows into all kinds of money pools (Zaitech and Tokin funds, investment clubs, mutual funds, LBO funds, venture capital, private equity, emerging market, art and collectibles, and equity, commodity and index funds). In this respect, the current asset boom is no different than previous investment manias, except that it includes all asset classes and is taking place practically everywhere in the world.
In the four great investment booms we have described, and also in previous investment manias, once the boom came to an end, most, if not all, of the price gains that occurred during the mania were given back. In 1992, silver prices were lower than they had been in 1974. In 2003, the Nikkei was lower than at its high in 1981. In 2002, in dollar terms, most Latin American markets were no higher than in 1990 and most Asian markets had declined to their mid- or late 1980s level. By 1998, the Russian stock market had given back its entire advance since 1994; and in 2002, most high-tech and telecommunication stocks were no higher than they had been in 1996 or 1997.
And in those manias where prices didn’t retreat in nominal terms to the level – or, as frequently happened, to below the level – from where the investment boom had begun (as was the case in 1932), prices retreated in inflation adjusted terms to those levels.
Adjusted for inflation, in 2001 the CRB Index was far lower than it had been in 1971, while precious metals, oil, and grains were all either no higher, or lower, than they had been in the early 1970s. Following all great investment booms, the leadership changed. The 1970s’ precious metal boom was followed by the boom in financial assets in the 1980s. The Japanese stock and real estate mania of the late 1980s and the emerging market boom of the early 1990s were followed by the parabolic rise of high-tech stocks in the late 1990s.
Therefore, while it is possible that in a prolonged environment of “excess liquidity” all asset markets could continue to increase in nominal value, it is most unlikely that the leaders of the previous boom – the US stock market and, specifically, the TMT sector – will be the leaders of the current asset inflation. And whereas it may be premature to make a final judgment about this point, as the current asset inflation could last for much longer, so far the gross underperformance of US equities and especially of the Nasdaq (still down by 50% from its 2000 high) compared to the emerging markets and commodities seems to confirm that the leadership has indeed changed.
for The Daily Reckoning
March 7, 2007
Editor’s note: 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.
Oh Alan! You ol’ devil, you!
Yes, our own dearly beloved former Chief of the Central Bank of the United States of America…more than four score years in age…and still full of mischief!
According to TIME magazine, Alan Greenspan was part of the committee that saved the world following the collapse of Longterm Capital Management in 1998. Then, after the dotcoms blew up…and after the Twin Towers came down…the Maestro saved the world again.
But only a little more than a week ago, it was he who practically destroyed it! That’s what some of the papers said. Greenspan, talking to a group in the Far East who paid $150,000 to hear the great man speak, said he wouldn’t be surprised to see a recession in the United States before the end of this year. Whether it was a coincidence or a matter of cause-and-effect we don’t know, but soon after all hell seemed to break loose in the Asian markets.
Here at The Daily Reckoning we took a philosophical view: All hell has been caged up for a long time; it was bound to break loose sooner or later. But a number of commentators scoured the scene of the break – and found the old man’s fingerprints! Mr. Greenspan himself didn’t seem to know if he was innocent or guilty. But he immediately moved to put some distance between himself and the pandemonium that seemed to be spreading throughout the world.
“I didn’t say recession was probable,” he noted carefully, “I only said it was possible.”
Then this week, when asked for clarification, he said he put the odds of a recession at one in three – directly contradicting his successor at the Fed, Ben Bernanke, who is telling everyone who will listen that today’s prosperity is eternal.
“We are in the sixth year of a recovery; imbalances can emerge as a result,” Bloomberg quoted Greenspan as saying.
Bernanke and Treasury Secretary Paulson are ready to say whatever investors want to hear. Yes, the economy is healthy. Yes, it may even be healthier by year-end. No, the trouble in subprime lending will not affect the broader credit market. No, there’s no need to worry about last week’s market jitters. Prices go up and prices go down; this is just a hiccup in a bull market, not the growl of a bear phase.
“Credit issues are there, but they are contained,” Paulson said to reporters in Tokyo during a four-day tour of Asia, speaking of problems in the subprime market. Goldman, his former employer, has seen its stock fall from 222 in February down to 190 this week. But, it’s not a concern, Paulson opined. The U.S. financial sector is robust and most institutions won’t feel ‘a big impact.’
We weren’t born yesterday – and, as far as we’re concerned, the two government shills are merely ‘talking their book.’ The last thing they want is a credit crisis. They’ll say what they have to in order to avoid it. As for what is ahead, they know no more than we do.
As predicted, the soothing words worked. Hell was backed in its cage yesterday. The Dow rose 157 points. Gold rose too – to $646.
Investors seem content to pin the blame for last week’s wobbles on Greenspan…or on the trade deficit…or on subprime mortgage troubles…or on the rising yen. Any culprit will do – except the real one.
The real devil is not an isolated, limited, or containable creature. He cannot be shut out, ignored, or rendered obsolete by sophisticated mathematics. Man is clever…but not that clever. He can invent such wonders as heavier-than-air flight and aged whiskey. But give him a laboratory and he can’t stop himself from inventing such nuisances as TV, NegAm mortgages and the Denver boot.
Alas, dear reader, this devil is as much a part of the market system as night is a part of a 24-hour day. Credit expands…and then contracts. Prices go up…and then go down. Sometimes the going is good…sometimes it is not. People are subject to periods of irrational exuberance…and to periods of irrational despair. As the world turns, there are bound to be times of darkness.
Today’s question is merely this: Are we looking at the sunset of the credit cycle…or just a passing cloud?
We will find out soon.
Dan Denning, reporting from Melbourne, Australia…
“Soothing axioms barely disguise the truth that markets today are more prone to volatility than ever, and that what we have witnessed over the last few trading days may be just a taste of what is to come.”
For the rest of this story, see today’s issue of The Rude Awakening
And more opinions…
*** Kevin Kerr, reporting from the Far East:
“A nasty rumor has been going around that the commodity markets are old hat and will soon go the way of the dinosaur. ‘They’ have been saying that since I started on the floor almost 20 years ago. I’m here to tell you that not only are these markets stronger and more modern than ever, but there’s never been a better time than right now for investors like you to make lifestyle-changing profits, and probably more quickly than you ever thought possible. I know, because I’ve done it myself!
“What happens when prices and demand for commodities run high over time? Lots of money gets reinvested into making more of that commodity. Pretty soon, you’ve got more of the resource than you need, just sitting in storerooms. Or how about hot demand that gets so hot there’s a correction? Prices for that resource plunge. And again, we make money simply by capitalizing on those moves.
“Over and over again, the cycle keeps playing out over time – especially today, with resource prices trading on more exchanges and more quickly than at any time in history. This may be your best chance in a long time to get very rich very quickly.”
*** Martin Hutchinson, author of the book Great Conservatives, looks ahead…to after the excess liquidity has leaked out of the liquidity bubble:
“…The United States and big borrowers of dollars will become unexpectedly weak, with their economies and stock markets faring worse than people predict. Long term interest rates will rise, which Federal Reserve Chairman Ben Bernanke will attempt to counteract by lowering short term rates. However he will find himself unable to do much because of an entirely unanticipated upsurge in inflation. His reassurances to the market that all is for the best in the best of all possible worlds, already utterly fatuous, will finally be seen as such by the wounded and angry denizens of Wall Street, who will ensure, as they face bankruptcy or more likely 20-year jail sentences, that Bernanke will not survive their departure. Needless to say the U.S. housing market, already suffering from its orgy of overbuying in 2001-05, will go into terminal collapse, probably taking Fannie Mae and Freddie Mac with it (oh, one hopes so!) and houses will thereafter be nice and affordable until about 2025.
“Outside the [United States], Britain, so proud of its position at the epicenter of the overblown speculations of world finance, will find its economy in collapse and London house prices dropping by more than half over the next [five] years. Only the Russian mafia, accustomed to stealing their money directly rather than through mere financial manipulation, will remain in London, more or less safe from Vladimir Putin, propping up the West End housing and luxury goods markets to a limited extent by their vulgar excess.”
*** Feeling lucky? Poor New Century Financial – a subprime lender – is getting hammered by the market and facing bankruptcy and an investigation by the feds. The price of the shares, when we looked yesterday, was below $5. What is remarkable about this is that, in terms of dividend yield, this may be the biggest bargain in the market. The Orange County Register reports:
“If you’re an investor who likes stocks that pay hefty dividends, New Century might send your head spinning in disbelief.
“On paper, the Irvine-based mortgage lender has a dividend yield of 51 percent to 167 percent, Register columnist Jonathan Lansner notes.
“In comparison, the yields of Edison International, Exxon Mobil and Procter & Gamble are about 2 percent, General Electric at about 3 percent, and Health Care Property Investors at about 5 percent.
“The yield is calculated by dividing a year’s worth of dividends – $7.60, assuming no change in New Century’s dividend rate – by the stock price. The price had dropped to $4.56 as of Monday’s close, which is why the yield is 167 percent.”
*** And our old friend, Rick Ackerman:
“My guess is that mounting worries about the stock market are about to deliver a devastating blow to a housing sector already verging on collapse. It doesn’t take a rocket scientist to see that that a full-blown housing bust could further depress stocks, setting in motion a destructive spiral as powerful as the financial-asset boom that preceded it.
“Fed to the rescue? For years we’ve been hearing that the central bank would never allow such a thing to happen. Well, it is happening, or at least it is beginning to happen, and the Fed has barely shifted gears. Meanwhile, for all of his unconvincing talk about the supposed threat of ‘inflation,’ one could say in his defense that Bernanke has merely been trying to distract us from the infinitely worse menace of deflation. To believe otherwise is to infer that the guy lacks the intelligence and the imagination to foresee how the deleveraging of the world’s $370 Trillion derivatives market might play out. We think he is smarter than that, and that is why we are holding to our lunatic-fringe prediction that administered rates are not only about to fall, but to fall quickly.”
But will that be enough to re-inflate the credit bubble? Maybe not.
Writes Ackerman: “A report just out from Merrill Lynch’s David Rosenberg raises the possibility that even a significant fall in mortgage rates might not do the job. ‘What drove the housing-led cycle was not as much the cost of credit,’ notes Rosenberg, ‘but rather the widespread availability of credit – irrespective of your FICO score.’ Rosenberg further questions whether the Fed can play a role as knight in shining armor after having acknowledged in a report published last August that ‘only a third of the parabolic run-up in the home price-to-rent ratio was due to low interest rates. The other two-thirds reflected other non-price influences, such as lax credit guidelines by the banks and mortgage brokers.'”