The Fed's War
It’s been a pretty bumpy year for investors…and looking forward, Marc Faber shares with us where to put your money (and what to steer clear of) in 2008.
The war between the Fed pumping money into the system and cutting the Fed fund rate to 2%, as David Rosenberg thinks, and the private sector withdrawing liquidity through huge write-offs in the financial sector, leading to shrinking balance sheets, will lead to increased volatility. Ten per cent market moves will be the order of the day. As was the case in the 1970s, we can expect the stock market to sell off by more than 20%. (Between 1968 and 1982, the stock market (S&P 500) had three major declines: 1968-1970: down 36%; 1973-1974: down 48%; 1980-1982: down 27%; and two minor declines: 1976-1978: down 19%; 1980: down 17%. At the time, the two adversaries facing each other were "easy monetary policies by the Fed" and "consumer price inflation".
Nobody won that war decisively, since stocks in 1982 were at about the same level they had been in 1964. However, since US equities had declined in real terms by 70% from their real 1966 peak to their real August low, one can assume that the Fed clearly lost that war.) Today, the adversaries are the private sector, which with its inflated asset values now wants to deflate, and the Fed, which under the present and last chairmen, never quite understood that larger and larger injections of liquidity into the system, leading to excessive debt growth, brings about a gross misallocation of capital.
I have no doubt that this war also will be lost by the Fed – if not in nominal terms, then in real terms, or adjusted for the sinking value of the US dollar. More to the point, this war has already been lost by the Fed: US equities fully recovered after October 2002 and made an all-time high in October 2007 in dollar terms, but even at their recent highs they were down by 37% in Euro terms (measured by the S&P 500) and by 60% in gold terms.
Still, we have to be mindful that even if the present economic and financial environment doesn’t look particularly enticing, as was the case between 1964 and 1982 when the market didn’t make any headway, plenty of investment opportunities will present themselves from time to time for the nimble trader and for the long-term investor who will be positioned in the few asset classes that will perform well. Moreover, it would be wrong simply to assume that recession and slumping corporate profit will inevitably knock down equity prices. Other factors such as negative real deposit rates and negative real yields on Treasury bonds because of the Fed driving down the Fed fund rate, a weak dollar, and "bubbly" emerging markets could make US equities a relatively attractive proposition compared to other financial assets.
Following this report, my friend George Karahalios – a very smart businessman who also happens to think and write clearly and has written for this report in the past – will make another strong case for precious metals and, in particular, for silver based on the gold-to-silver ratio declining further (meaning that silver will outperform gold). I am less certain about this occurring than he is, but that is irrelevant. What is relevant, however, is that – with Bernanke at the Fed and Paulson at the Treasury, and a Euro that could face some problems (a break-up, some believe) because of badly deteriorating economic conditions in Italy, Spain, Portugal, and Greece – precious metals are likely to outperform financial assets for some years to come. As Michael Berry remarked, "Gold is no friend to the world’s central bankers. The printing press is their friend." In fact, I would be very surprised if the Dow Jones Industrials/Gold Ratio didn’t decline to between 5 and 10 within the next three years at the outside. Therefore, I should like to reiterate my recommendation to accumulate gold. Both George and I agree, however, on one point: the precious metals bubble will be the last to burst.
Other commodities that could come to life in 2008 are sugar, cotton, natural gas, and palladium. Moreover, as Robert Mitchell (firstname.lastname@example.org) suggests at the very end of this report, uranium is unlikely to disappoint the longs. (Robert recommended in this report the purchase of uranium back in 2005.) Uranium Participation Corporation, listed in Canada (U CN), tracks the price of uranium. In general, some special situations aside, I am not positive for industrial commodities in a slow growth or recession type of environment.
Among commodities and currencies, my preferred asset remains physical gold held outside the US, for the simple reason that – depression or inflation – it is very likely to outperform financial assets. For gold, I believe the best is yet to come!
In terms of equities, I remain very cautious. It is difficult to find compelling values. Singapore REITs have declined by between 20% and 30% from their summer peak and, yielding around 5% to 6%, would seem to offer relative good value (given the soundness of the Singapore economy and its currency).
I still like the agricultural sector. Investors should consider buying the Dow Jones – AIG Agricultural Total Return Sub Index ETF (JJA). Japanese equities are out of favour and so, as a contrarian play for 2008, are among my top picks.
On the short side, I am inclined to think that most emerging markets have already topped out or will do so in the next six months or so. Given my less than optimistic take on the economy, I would also avoid all economically sensitive stocks irrespective of whether it is an economically hypersensitive stock market such as Korea, or retailers, basic and cyclical stocks such as steel, paper, engineering construction, and even energy and energy-related – at least for now. I would also avoid technology shares, since their two largest customers – consumers and the financial sector – are likely to perform poorly.
The current stock market decline will only end once the stocks that form the last bastion of strength succumb to heavy selling. For all short positions, stop loss orders are recommended and, as with longs, each individual is responsible for his or her own decisions based on his or her financial condition. It is physically not possible for me to be a financial planner for all my readers.
Aside from Japanese equities, a contrarian play would be to buy the US dollar. Perhaps we could still see a final dollar sell-off, but sentiment and headlines are so universally negative that at least a short-term rally should get underway shortly. The only problem I have with being positive about the dollar is that, whereas people are universally bearish about the dollar, they are also universally still long a gargantuan quantity of dollars! Still, starting January, seasonal strength should begin to be dollar supportive.
Have a happy New Year,
for The Daily Reckoning
December 20, 2007
We are piling up those frequent flier miles!
Last night, we were checking in for the flight to Buenos Aires. The woman at the counter looked on her screen.
"Mr. Bonner…would you like to upgrade your ticket? You’ve got a lot of frequent flier miles."
For $100 and 25,000 miles we moved up to first class.
It’s a long haul down to South America. The $100 was well spent. We were able to go to sleep…and stay asleep for almost the entire flight. We only woke up in order to pull out our laptop computer so we could write to our dear, dear readers.
But what is there to say? A dull day on Wall Street? Everything has already been said?
Ah, there is always something to say.
"If your daily life seems poor," said Rilke, "do not blame it; blame yourself, tell yourself that you are not poet enough to call forth its riches."
Yesterday, the markets were quiet. Gold is holding over $800. Oil is holding over $90. And the Dow is still refusing to crack. Of course, it depends on how you keep score. We announced our Trade of the Decade in 2000 or 2001; we can’t remember. "Sell the Dow; buy gold" was our simple advice. The ratio of Dow to gold actually hit a high in August ’99 – at about 44 ounces of gold to the Dow. Now, in terms of gold, the Dow has been more than cut in half. You can get the whole thing for only about 18 ounces of gold. The decade has another three years to run. We’ll stick with the trade, just to see what happens. The Dow has already run down in terms of gold. Our guess is that it will run down in terms of dollars too – probably in terms of nominal dollars and certainly in terms of real (inflation-adjusted) dollars.
Commodities reached a new high yesterday – another solid hit from the fist of inflation.
Inflation reeled, and then delivered a jab – foreclosures rose 68% in November…and then another jab – home construction is at the lowest level in 16 years. As a share of the GDP, residential construction has reverted to the mean – it’s back to where it was before the great property bubble began in 2001.
David Rosenberg of Merrill (NYSE:MER) connects home building to home ownership to consumer spending. In the bubble period, builders put up houses, sold them to people who had never owned homes before – homeownership went from 65% to 70% – and then the new homeowners started spending. They were able to spend more than ever before because for the first time in their lives they had an asset that was rising in price. Consumer spending went up with home ownership – from 65% of GDP to over 70%.
But now, homeownership rates are falling again. They’re reverting to the mean – which is about 65%. And consumer spending seems to be following, reverting to the mean too.
Rosenberg thinks this process of reverting to the mean in homeownership and consumer spending will be so painful, the Fed will drop rates back to 2% to try to combat it.
We think he is right.
But let’s keep moving…let us draw forth some richness elsewhere. Let us look at the big picture. Ah, here is where it gets very, very interesting.
The Reagan/Thatcher revolutions brought subtle changes to the English-speaking world. People said that these victories were triumphs for conservatism and for laissez-faire capitalism. But they missed the point completely. The Reagan/Thatcher revolutions brought new ideas that had little to do with conservatism or free market principles. What they really brought was a form of enlightened socialism…a way of harnessing market forces for the benefit of the state and the elites who control it.
That was the genius of Arthur Laffer’s celebrated curve. You could lower tax rates, he said…not because people should be allowed to spend their own money…but because it would actually increase tax revenues to the government! Likewise, reducing regulation in some areas would increase economic activity, increase GDP, increase tax receipts and result in more money and power for the politicians.
Clever. Very clever. And what difference did it make if their motives were not exactly those of true conservatives? They were headed in the right direct; that was enough. But now it is a quarter of a century later. Now, we are just beginning to realize what has been wrought: The horrors. The horrors still to come. (Interestingly, we are interviewing Dr. Laffer today, for our upcoming documentary, I.O.U.S.A., which premiers at the Sundance Film Festival next month. We’ll let you know how it goes…)
The old conservatives would have been happy to see taxes cut. As we old, fuddy duddies here at The Daily Reckoning put it: we’ve never met a tax cut we didn’t like. But the old conservatives insisted on cutting spending too. "Balance the budget" was an old-time conservative gospel lesson. The new conservatives ignored it completely. "Deficits don’t matter," they said. As it turned out, they had another agenda. And that agenda required money…lots of money.
Then, when Mr. Alan Greenspan was brought in to manage the Fed, it looked to many people as though the government was going further in the direction of laissez-faire economics. Not so again. Soon the entire world financial system was set to work in a perverse new way…
If any readers think they know where we are going with this…please contact us immediately…we’d like to know!
*** Murray Rothbard had Alan Greenspan’s number a long time ago. (Many thanks to our old friend Marc Faber for bringing this gem to our attention.)
"I knew Alan thirty years ago," Rothbard wrote in 1987, when Greenspan was first appointed to head the Fed. "and have followed his career with great interest since…Greenspan’s real qualification is that he can be trusted never to rock the establishment’s boat…at no time in his twenty-year career in politics has he ever advocated anything that even remotely smacks of laissez-faire, or even any approach toward it… Alan is a long-time member of the famed Trilateral Commission, the Rockefeller-dominated pinnacle of the financial-political power elite in this country. And as he assumes his post as head of the Fed, he leaves his honored place on the board of directors of J.P. Morgan & Co. and Morgan Guaranty Trust."
It was pointed out that Greenspan had been a devotee of Ayn Rand, who had the quirky presence of mind to die on Alan’s birthday. But Randism is not laissez-faire-ism. Randism is looking-out-for-number-one-ism…a creed Alan Greenspan never forgot.
We are annoyed at Alan Greenspan, not because he set the U.S. middle class on the path to destruction but because his book, The Age of Turbulence, got so much more attention than the book we wrote with Lila Rajiva, Mobs, Messiahs, and Markets. Mr. Greenspan’s empty tome came out right after ours…and promptly knocked ours out of its brief moment in the limelight.
But now others are getting annoyed at Mr. Greenspan too – for more serious reasons. Says Nobel Prize winning economist Joseph Stiglitz:
"Alan Greenspan really made a mess of all this. He pushed out too much liquidity at the wrong time. He supported the tax cut in 2001, which is the beginning of these problems [deficits didn’t matter to him, either]…He encouraged people tot take out variable rate mortgages."
The critique we leveled against the Greenspan Fed three years ago is now widely accepted; the feds saw the little recession of ’01…and panicked. They put out too much money and too much credit for much too long, causing bubbles all over the world. So free and easy were American banks and credit institutions during this period that bank robbers stopped wearing ski masks and carrying guns; all they had to do was to ask for the money like everyone else.
The free-floating loot produced a holiday atmosphere that looked to most people like real prosperity. "See," they said to each other, "the free market works."
"Greed is good," said Gordon Gekko. Financial incentives were thought to be the key to everything – higher productivity, higher profits, growth…everything. You want an executive to perform? Give him stock options! You want an investment manager to make you money? Give him a piece of the action. You want to win over the poor and minorities? Let them get in on this great money making machine. Remember all those columns by Thomas L. Friedman that we made fun of? Friedman keeps telling us that the terrorists would come over to our side if they just had more financial incentives…if they had jobs…if they had university degrees…if they had credit cards and mortgages. But it emerged in England that of the terrorist suspects nabbed so far, the average one was a doctor working for the National Health Service!
Money isn’t everything. Especially the kind of money that the Fed creates.
More to come…
*** "Florida doesn’t tax income," explained a friend yesterday. "But they hit you hard on property taxes. I pay close to 2% of market value. And market values have gone way, way up. So, even though I don’t have a mortgage, I end up paying the equivalent of a mortgage on a reasonably-priced house. See what I mean? My house has doubled in price in the last five years…actually much more than that, but let’s keep it simple. So if I pay 2% on the value of my house today, it’s the same as 4% on what the house is really worth. I’m protected a bit because I’ve owned this for a long time…and it takes them a while to catch up to the market. But imagine some fellow who bought recently. He paid top dollar…and he’s got the property taxes to pay too. And, of course, that’s just the beginning. If I want to ensure against hurricane damage…that’s thousands more. And then there’s regular maintenance, utilities…etc. etc. Home ownership is a big pain in the neck."
"I’ll tell you what’s going to happen. People are going to turn away from big, expensive houses. I feel it happening. It’s part of a change in sentiment. The baby boomers who’ve been buying these things are running out of money and credit. They’re going to be forced to cut back. And I remember you wrote once something that stuck in my mind – ‘people come to think what they have to think when they have to think it’ – or something like that. That’s what I expect. People without money are going to come to think that not having money is cool. They’re going to downsize. And they’re going to think that people who drive big, expensive cars…or live in big, expensive houses are uncool. Already, when I drive around in my 12-cylinder BMW I feel my neighbors laughing at me. It was cool a couple of years ago to have a car like that. Now, it’s uncool. Everybody thinks you’re out-of-style; it’s as if you had a mullet…or a polyester leisure suit, but those are probably coming back in style. And they think you’re destroying the environment too."
The Daily Reckoning