Too Many Treasure Hunters
In the "huge brothel" of the financial services industry, writes Dr. Marc Faber, wealth is not created, consciences are not followed, and though clients may be temporarily satisfied, the good times cannot last forever.
The investment management industry has become a huge sector of the economy in most industrialized countries, and the money that is sloshing around the world now dwarfs the real economy by an unprecedented margin. Just consider that in the United States, manufacturing employment has declined to its lowest level since the 1950s, while debt-to-GDP is at a record high and continues to rise, and stock market capitalization as a percentage of the GDP is near a record.
Put simply, we seem to be producing less in the way of goods as a percentage of the economy, but an increasing amount of paper money at a faster and faster clip. These trends lead to the disproportionate growth of the financial markets compared to the real economy. If they persist, which I doubt they can do forever, eventually the Western industrialized nations will produce very little (as a percentage of GDP), but instead an ever-growing army of investment wizards will spend their days trading financial instruments, including stocks, bonds, mortgages, currencies, options, derivatives, and so on!
How sustainable is such a trend when, in fact, financial markets by themselves don’t create wealth, but are a byproduct of wealth creation in the real economy? This may be a controversial question, but let us compare two economies for a moment. In the first economy, people work in factories and the services sector and invest their savings to boost the output of goods and services. In this economy, the financial economy only serves as a conduit for channeling savings into investments. In the second economy, the entire population has largely given up on working and instead trades financial instruments 24 hours a day.
Momentum Investing: Imaginary Wealth
It is easy to see that both economies could have full employment and "growth" – provided, however, that the monetary authorities continuously expand the quantity of money in the economy where the entire population is engaged in the financial market. But, real wealth would only be created in the economy that produces goods and provides services and annually channels its savings into net new investments (capital spending exceeding depreciation charges); the purely financial market economy would only produce paper or imaginary wealth, which would not be sustainable in the long run.
To put it another way, the economy producing goods and services builds wealth based on its investments in new technologies and structures (net new investments), whereas the purely financial economy builds its "wealth" on financial asset inflation, which at some point inevitably spills over into hard asset inflation as well (real estate, art, commodities, etc.), but which does not produce any new "real" investments.
Now, I am not suggesting that the United States has already reached this hypothetical stage of economic development – after all, it is not unusual that, with fewer workers in the manufacturing sector, more goods can be produced through improved productivity – but we are steadily getting closer to this situation. (Productivity gains aside, one should not forget that more and more retirees are being supported by fewer and fewer workers.) According to The King Report, which is an excellent daily economic and financial newsletter, 350,000 General Motors retirees are supported by 118,000 GM workers, half of whom, according to GM, are due to retire over the next five years. Therefore, there will soon be more than 400,000 retirees supported by fewer than 100,000 workers!
Momentum Investing: US Dollar Bear Market
One of the symptoms of an economy that creates "artificial wealth" through asset inflation is the weakening trend of its currency, as the asset inflation makes its price level relatively expensive for the production of goods and tradable services, when compared to countries whose price increases are contained by an increase in the supply of goods and services as a result of real capital formation. In other words, the longer the Fed attempts to kick-start the U.S. economy through asset inflation with ultra-easy monetary policies, the longer the U.S. dollar bear market can be expected to last.
But that aside, there is another angle to the financial markets and the financial services industry becoming so huge when compared to the real economy that I wish to address. (In the first nine months of 2003, global capital market debt issuance surged 22% to US$3.72 trillion compared to 2002.) For an analyst, a fund manager, or a strategist, the analysis of companies and macroeconomic fundamentals begins to take a back seat. Of more importance is their analysis of what their peers in the financial industry are thinking, how they are currently positioned, and in what way they might change their positions in the future.
In other words, in terms of one’s performance, what one thinks of a stock, a sector, or a country is less important than what other fund managers and investors might think about the same assets. Therefore, as silly as it may sound, an analyst attending a company presentation at a conference should actually pay less attention to what the company has to say than to the reactions of the other fund managers about what the company is presenting. If the company’s presentation is well received, the other fund managers will immediately place buy orders for shares of that company; whereas if the presentation disappoints the fund management community, sell orders will follow.
Momentum Investing: The Momentum Players Were At It
Now, I am not suggesting that this "momentum" investing style will yield substantial returns in the long run, but in many cases stocks can have large moves for totally wrong reasons. A good example of this would be the sharp gains Eastman Kodak shares had in the late 1990s, when digital photography was just beginning to proliferate.
Even a relatively superficial analysis would have shown that a company whose profits depend largely on selling nonreusable films and developing them could only lose from the new digital photo technology, which is bound, over time, to make non-reusable films obsolete. But the momentum players were at it and drove the shares to their highest level ever, dead ahead of the worst disaster in the company’s history – the loss of a fantastic franchise and the duopoly in the photo industry it had shared for the last 20 or so years with Fuji Photo.
I have mentioned this because of the recent strong rebound and significant outperformance of the old high-tech favorites of the 1998-2000 bull market. In the same way that many of the "nifty fifty" stocks in the 1970s, including Kodak and Xerox, broke down in 1978 below their 1974 lows, we could also see, after the current rebound runs its course, new lows in Nasdaq stocks sometime in the next few years. In addition, we can see that Eastman Kodak and, I might add, the entire "nifty fifty" sector of the early 1970s weren’t good investments after 1973. For most of the 1980s and early 1990s, Kodak and Xerox (as well as Polaroid, which went bust last year) were lower than in the early 1970s and, inflation-adjusted (in real terms), never actually made new highs above their peaks in 1973!
Kodak is an interesting example of a "high-quality" company that fell on hard times for no other reason than "creative destruction" as a result of a new technology, and one has to wonder how many of today’s favorite momentum stocks, such as Cisco, Intel, Microsoft, Oracle, Sun, etc., will eventually encounter a similar fate. In fact, Hewlett- Packard would seem to have many similarities to Eastman Kodak, since sales of cartridges and toners for printers subsidize the entire company.
Stocks do not always go up in the long run. The reality is that most companies go out of business in the long term, and investors must continuously look for new companies, regions, sectors, and asset classes within the investment universe. After a bubble bursts, there is always a change in leadership, a fact which investors much also take into account.
Momentum Investing: Defense or Momentum?
In today’s investment climate, those fund managers who share my concerns about the U.S. economy have only two choices when confronted with a rising market. Either they can stick to their defensive strategies (high cash position and ownership of low-volatility stocks) and risk their jobs, bonuses, and the loss of impatient clients, as they are bound to underperform the market for some time; or, despite being bearish at heart, they can go long the sectors with the strongest momentum and, often, also the weakest long-term fundamentals and highest valuations (high-tech stocks over the last six months) and perform admirably well.
The reader will easily be able to see which choice most fund managers will take. In fact, I feel sorry that some of my friends who are first-class thinkers and analysts are forced to take investment decisions based on market momentum, in order to perform and keep their jobs and their clients, but which run totally contrary to their own fundamental analysis and judgment.
It may sound harsh, but the entire financial service industry is like a huge brothel. The brokers push stocks they know nothing about, but which move and, therefore, can be turned over quickly, thus generating commissions. The analysts recommend stocks not necessarily based on sound fundamentals, but because they are showing signs of rising momentum as other analysts are also recommending them. And the fund managers are forced by the brothel’s owners to perform by buying sectors that they don’t really like but which will, as they soar, give full satisfaction to the brothel’s clients. In the meantime, newsletter writers and financial advisors like myself are also actively prostituting them, as our clients also expect – aside from just sound financial advice – some moneymaking ideas.
I wish to stress that while I am critical of the financial system and the gargantuan financial service industry, which forces its professionals to invest increasingly according to momentum (excessive liquidity), I am not critical of most of the very brilliant fund managers, strategists, and analysts I come across. In fact, I am stunned again and again by the quality of analysis, breadth of knowledge, and fine personalities of the people I meet in the financial service industry, but sadly, the relentless supply of new paper money created by the Fed forces all of us to act in a way that doesn’t always conform to our own beliefs.
For my taste, the Western financial markets are too large compared to the real economy and will have to be deflated at some point much further than has already happened since 2000. There are also too many smart people and treasure hunters involved in the financial service industry, which makes it more difficult for the average investor to perform well.
Valuations remain extremely high and the renewed leadership of the old favorites is more of a symptom that the recent strength is a powerful bear market rally within a long-term downtrend, which is once again likely to fool the majority, than the beginning of a new bull market. The old leaders and current momentum plays are likely to disappoint at some point, in the same way that Eastman Kodak, Polaroid, and Xerox performed poorly after the 1973 bubble peak in the "nifty fifty" stocks.
In fact, I don’t believe that the current environment presents excellent entry points for most financial assets. If the correction does not come now, it is likely to be far more severe later and, therefore, investors will be in a position to buy most financial assets cheaper sometime within the next 12-18 months.
for the Daily Reckoning
November 12, 2003
Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report, as well as a frequent contributor to Strategic Investment. Headquartered in Hong Kong for the past 20 years, 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.
A version of this essay was first published in Strategic Investment. If you’d like to find out how to benefit from hard assets in a way consistent with this essay.
Looking ahead to where the real growth opportunities of the next 30 years lie, Dr. Faber has distilled his analyses into the ground-breaking book, "Tomorrow’s Gold" – a wake-up call to Western investors.
The citizens of Squanderville, as Warren Buffett calls the U.S. in his Fortune article, are a happy race. They believe happy things; it doesn’t bother them that the things they believe are impossible.
After twenty years of mostly falling interest rates… mostly falling inflation rates… and mostly rising asset prices (stocks and real estate), people have come to believe that this is the way the world works in Squanderville. And since interest rates mostly go down, and house prices mostly go up, they figure they have little to worry about.
Even the professionals in Squanderville have never been more certain: a recent poll of economists working for major brokerage houses found that 100% of them expected rising stock prices over the next 12 months. And real estate? Who believes house prices will fall?
Well, John Talbott, for one. He’s the author of "The Coming Crash in the Housing Markets."
Mr. Talbott expects the housing market to collapse when interest rates rise. Higher rates mean higher monthly payments. Since few people have much extra capacity in their monthly budgets, higher mortgage payments will make it difficult to pay high prices… forcing down the general level of prices, just as low interest rates drove them up.
Curiously, the same economists who expect higher stock prices also expect the Fed to raise rates by the middle of next year. Australia and Britain have already begun tightening interest rates; it is only a matter of time, they think, before the U.S. follows suit. In their simple minds, the Fed’s low rates have produced a ‘recovery’ as good as any other. It will be followed, they believe, by the usual pattern of trends: higher employment, higher prices, and higher interest rates.
Nor are they especially worried. For the economists of Squanderville expect the recovery to produce more jobs and higher real incomes, with enough extra earning power to offset the rise in interest rates.
On this last point, we suspect they will be met with some disappointment. For, while it is all very well to think happy thoughts and spend happy money, it is savings and investment that produce real jobs and real earnings. But when Squandervillians refinance their homes so they can continue spending, much of the money now makes its way over to Thriftville (Warren Buffett’s term, perhaps with China in mind).
As the years go by, Squandervillians make less and less… and consume more and more. So, when they spend money… much of it goes to buy products from the Thriftvillians. These industrious people use the money to hire more workers, build more factories, import more technology, and improve their products. Thus do the authorities in Squanderville find themselves in a remarkable position: they can still use monetary and fiscal policy to create a boom, but the boom happens in Thriftville!
But the happy residents of Squanderville hardly know or care. The latest job numbers are celebrated; who bothers to notice that the new jobs were not quite as nice as the old ones? While companies lay off relatively highly paid people in the manufacturing sector, other companies hire relatively more cheap employees in the service sector.
Interest rates are likely to rise in Squanderville, but not coincident with a boom in real jobs and real wealth. Instead, rates will likely rise as the happy country’s currency falls. Desperate for foreign financing, it will be forced to increase the rate of return on its bonds.
This will not help Squanderville’s homeowners. They are counting on low rates… and higher prices. Instead, they will likely get higher rates and low prices. And lower real incomes too. Foreclosure rates are already setting all-time records.
What would happen if real estate prices actually started to go down while interest rates rose? They would switch to adjustable rate mortgages to ease the monthly pain, figuring that rates would return to lower levels. But as rates continued to rise… and house prices fell… every adjustment would go against them.
Soon, the homeowners of Squanderville might be faced with a brief interval of horrible sanity… and they may discover that things didn’t really work the way they thought, after all. They may be unhappy.
Addison, any further news?
Addison Wiggin, casting an eye over the days stock news…
– Mr. Market celebrated Remembrance Day yesterday in a way that was almost – how shall we say? – logical. He suddenly appeared to remember that this is just a bear market rally, albeit a whopper, and that stocks are far too highly valued. The Dow shed some of the overvaluation, closing down 18 points to 9737. The S&P 500 lost a point to 1046. The Nasdaq fell 10 to 1930.
– A growing number of economists are beginning to decry the flurry of so-called positive economic numbers that inundated the market last week. "We hate to be party poopers," David Rosenberg, chief North American economist for Merrill Lynch, told Yahoo! News yesterday, "but how can any labor market report be classified as strong when the index of aggregate hours worked is down .1% in construction and .2% in manufacturing?"
– "All in all, the proverbial glass still looks half-empty to me," Morgan Stanley’s Stephen Roach agreed. "For a saving-short, overly-indebted, poor economy, I continue to think it’s entirely premature to issue an all-clear sign."
– "I am not nervously bearish or on the fence," says our friend Bob Prechter, taking the case a little farther, "I am all-out, no-holds-barred, shout-from-the-rooftops, yet- another-opportunity-of-a-lifetime bearish. Wave patterns, cycles and technical indicators have developed into an astonishingly one-sided message. A market analyst dreams about a confluence of indications this extreme.
– "I have been fortunate in so far living through two such periods in the stock market," Prechter continues. "The first time was 1975-1984, when fear reigned on every setback. Meanwhile, the bull market was roaring in the average stock and gearing up for greatness in the blue chips. The second time has been from 1998 to now, when giddy euphoria has reigned on every market resurgence. Meanwhile, the bear market has had its way with the average stock and is gearing up for greatness in the blue chips.
– "The primary oddity of both periods is the incredibly long time that each one has taken. Three hundred years of stock market data show nothing else like it. Extreme technical conditions that used to be reconciled in weeks have taken months, and those that used to take months have taken years.
– "After this bear market is finally over," Prechter predicts, "almost no one will remember the Pollyanna psychology that existed in the summer of 2000, the spring of 2001, the spring of 2002 or the fall of 2003. The S&P and NASDAQ will look like one big slide with a few rallies along the way, and historians will probably not even imagine that investors could have been stark raving bullish during any one of them."
If you’re not familiar with them, the folks at Elliott Wave have been providing world-class market analysis since 1979. Bob Prechter is one of the more highly respected technical analysts in the field. He was also kind enough to give us a critical review for Financial Reckoning Day. With this offer, for one full week, you’ll get specific Elliott Wave forecasts for every major market in the world. It’s worth a try.
– So… what really caused the ‘phony’ boom? In the early summer, the money supply grew at a phenomenal rate – up 22% annualized. Federal spending boomed, too – largely in connection with the war against Iraq. In the space of 18 months, fiscal policy went from surplus to the largest deficit in history – a swing of three quarters of a trillion dollars.
– And then… what’s next, we ask again? Will the Federal government run even bigger deficits? Will rates be cut a 14th and 15th time… right down to zero? Will the money supply increase at a 50% annual rate?
– What will stimulate the economy in the months ahead? We don’t know. But we note, ominously, that the rate of increase in the money supply… and the velocity of money… are both falling. And mortgage rates are beginning to rise… oh, là là…
– Not in 50 years has America had a nationwide collapse in real estate prices. But there have been regional bear markets. In New York City, prices fell 8% and took 10 years to recover. In Houston, prices fell 21% and took 7 years to recover. Hartford saw prices drop 23%. Residents waited 13 years before prices came back to their highs. Boston property prices went down 6% and did not come back for 6 years.
– Of course, in Japan, property prices have still not recovered from their collapse following the bear market in stocks that began in January of 1990.
– John Talbott, whom Bill mentions above, would not be surprised to see U.S. real estate prices fall by 30%. What would you do if your house were worth 30% less than you paid for it? Most people say they would just sit tight and wait it out. They’re confident that prices of real estate would bounce back… just like the stock market. "Don’t sell at the bottom," their neighbors would say.
– But people sell houses out of necessity, not choice. They get divorced, or lose their jobs, or find better jobs elsewhere. Then, when they are forced to sell, the price they get for their house – even if it is a distress sale – establishes a new benchmark for the entire neighborhood.
– Meanwhile, Marc Faber thinks we’re not far away from tracking housing starts and retail sales in China as a measure of global economic activity. In an interview with our friend, CBS’ Scott Burns, following his speech last week in New Orleans, Faber suggested it’s merely a function of population numbers.
– Burns: "Faber points out that Swiss per-capita consumption of chocolate is very high – but the tiniest increase in Chinese per-capita chocolate consumption would simply dwarf Swiss demand. That’s what a small change in a nation of nearly 1.3 billion people does. Ditto lumber, grain, oil, copper, aluminum and just about anything else. Double the per-capita income of a nation that is four times larger than ours in 10 years, quadruple it in 20, with plenty of room for continued growth, and global equity values will shift.
"We’ll be saying goodbye to hegemony before we learn how to pronounce it." More from Dr. Faber in a Daily Reckoning guest essay… below…
Bill Bonner, back in Paris…
*** IPOs are back, says the Wall Street Journal. Day trading, too. The average stock on the Nasdaq sells for over 40 times earnings – and many have no earnings. Consumers are spending more than ever. And margin debt is back to where it was in ’99.
As philosophers, we are distressed. But as investors, we are delighted; nothing warms the greedy cockles of an investor’s heart so much as seeing so many people doing so many stupid things.
Jeremy Grantham says this is a "suckers’ rally" on Wall Street. Buffett says he can’t find anything worth buying; he’s moving his money to foreign currencies for the first time in 72 years. Soros warns that the whole thing is going to blow up. John Templeton warns investors to get out. Richard Russell warned last week in New Orleans, "If ever there was a crisis that could shake the global economy – this is it!" Our friend Jim Rogers is even teaching his young daughter to speak Chinese!
But the average investor thinks he is smarter than Buffett, Soros, Templeton, Rogers, Russell and Grantham. And thank God for him! Without the young lumps, who would the old pros sell to?
*** We came back to Paris earlier than expected. We had intended to spend a week in New York doing a promotional tour, but the project was postponed.
"You know," explained the publicist, "with the market and the economy doing so well… the major media don’t want to talk to you. Nobody wants to hear a gloom and doom message now. But don’t worry; your book is selling well anyway."
In fact, we learned yesterday that we’ve debuted on the New York Times Business Bestseller list at #7 this week. (We had previously been ‘tracking’ on the overall ‘hard cover’ advice list, but this Business list debut is the real deal.) Special thanks are in order for the members of the FRD brigade – bravo!
*** We wanted to ask our local Oracle… a drunk who hangs out on the street near the office… what he thought of America’s ‘recovery.’ But we found a notice on the door of St. Merry’s church informing us that the tramp had died. We imagine he just passed out on the steps of the church, as he always did, and never woke up. He was probably scooped up by the garbage men as they made their rounds. The whole thing is so sad; his investment forecasts were as good as any other, and much cheaper. What can we say? The good die young. RIP.
*** Catching up on family news…
Henry’s class has been called to Rome for a meeting with the Pope. We don’t know the purpose of the visit, but his mother is concerned about it. She’s set up a meeting with the school priest.
"What’s the matter," we wanted to know.
"Well, Henry is not really Catholic," she explained.
"Huh? He goes to Catholic school. He goes to mass. He’s been confirmed in the Catholic Church. He’s even an altar boy. You don’t get much more Catholic than that."
"Yes, but he was baptized an Episcopalian."
"I don’t know… but I think we should find out before the Vatican does."
"They must have more important things to worry about… "
*** "Maria," we began the question, "how did your audition for the Royal Academy go?"
"Well, I cried when I came out of it. But the woman running the program told us not to worry. She explained that as an actress, you have to be twice as tough as everyone else. Because you’re always trying out for things… and you don’t get many jobs.
"I think I better apply to other schools… just in case… "