Very Modest Good News

With all the recent downturns in the markets, many investors aren’t sure where to put their money. Dr. Marc Faber, however, sees a light – albeit, a dim light – at the end of the tunnel, and offers some advice.

I can see some – albeit very modest – improvement for the US stock market. For one, it appears that the slowdown and problems in other economies, such as the UK (a disaster waiting to happen), Italy, Spain, and Ireland, are even greater than in the US. Also, since numerous emerging stock markets have underperformed the US this year, some money is likely to be repatriated from countries such as India and China, where stock markets are down approximately 40% year-to-date. We should also consider that, as Joachim Fels noted, "Fifty of the 190 or so countries in the world now have inflation running at double-digit rates. Almost all of these are EM economies." In my opinion, some emerging economies – contrary to expectations – could therefore be hit even harder than the US. So, the good news here is that the "bad news" is even worse in some other countries than in the US (though this may be hard to believe).

The media and some market commentators who were "bullish" until late June have noticed recently that we are in a bear market, because the major indices are down roughly 20% from their peak. This is a remarkable achievement in the annals of forecasting and market timing! How many stocks had to drop by between 50% and 99% before the media and some "bulls" who have continued to talk about another upward wave in stock prices being just around the corner, which would supposedly lift the indices to new highs, finally accepted that we are now in a bear market? Don’t forget that when stock market indices made new highs seven months ago, the media and most advisers were exuberantly optimistic – although most stocks were then already in downtrends. Moreover, sentiment figures (bulls versus bears) among individual investors and investment advisers are now heavily tilted towards the bearish side. Whenever sentiment has been this negative in the past, the odds favoured at least a short term rally. Still, I need to warn our readers that since sentiment remained so extremely optimistic between 2003 and 2007 while the stock market rose, it is possible that sentiment will remain extremely negative for a long time while the market continues to decline.

The third improvement I have noticed is that, from a technical point of view, the market has become "quite" (though not extremely) oversold. But again, I need to warn here that the market would now be oversold in the context of a bull market – not in the context of a bear market, during which the oversold condition could last for a very long time. I suppose that Ambac was already oversold at US$70, and where is the stock now? Moreover, at major turning points, markets can quickly reach oversold or overbought conditions and then work out these conditions without large corrections. Let me explain.

In the summer of 1982, US equities had become extremely depressed; they were no higher than in 1964, and were down in real terms by more than 70% from their 1966 "real" high. The Dow bottomed out at 769 on August 9 and, if I recall correctly, the stock market took off on August 18. By September 22, the Dow had reached 951 (up more than 20% from the August low). The two most overbought conditions I have seen up to that time had occurred at the end of August 1982, and then again on September 22. But, thereafter, the market continued to rise: to 1296 in November 1983, to 2746 at the August 1987 peak, and to the recent high of 14,198 on October 12, 2007.

So, I wish to stress that overbought and oversold conditions must always be put in the context of both the primary trend – up or down – and the phase of the bull or bear market in which they show up. Overbought conditions at the beginning of an uptrend, and oversold conditions at the beginning of a downtrend, are meaningless from a longer-term perspective! If we are indeed in a bear market, which is my view – and has been since the summer of 2007, the current oversold position is relevant only from a very short-term point of view.

The fourth improvement I see is that some previously strong stocks and groups such as US Steel (X), Cleveland-Cliffs (CLF), IBM, and the oil sector, as well as the Nasdaq and some of its leaders such as Research in Motion (RIMM), Apple (AAPL), etc, are beginning to turn down. For the market leaders to collapse is an important precondition for a major low. But again, we need to understand that it will take much longer, and far lower prices, before the very strong stocks and sectors (mostly energy-related and materials) that have so far defied the bear market in financial stocks reach a major low.

Since I fully expect the financial crisis to spread into the real economy, I would sell those sectors and stocks that have so far defied the weakness in financial stocks. Another potentially good piece of news is that the current expansionary monetary policies make the stronger companies in an industry relatively stronger than their weaker competitors, which would then be reflected in strongly diverging stock performances. The weak company stocks could decline so much as to make them, at some point, attractive merger and acquisitions candidates for the financially stronger companies. Industry consolidation would in this scenario accelerate and lead to stronger pricing power (and inflation).

The last potentially good bit of news is that oil and other commodity prices may have reached an intermediate top. Should oil prices decline by, say, 20% to 40%, this fact will certainly be broadcasted by the media – as well as by ignorant cheerleaders and people who still don’t regard commodities as an asset class – as great news for the stock market! A relief rally would likely follow. But wait a minute: why would oil prices and other commodities decline meaningfully? Because of a lack of affordability and a weak economy around the world – not just in the US! This would lead to declining demand for raw materials and likely lower prices. (Supplies are unlikely to increase significantly, but they could be cut as a result of war, civil strife, or concerted action by the producers.) However, a weak economy or economic contraction around the world would be unlikely to be favourable for equities and corporate profits.

I need to make one more comment with respect to oil prices and commodities. It is not a strong US dollar that will lead to declining oil prices, as some commentators argue. What will bring about lower oil prices is a collapse of consumer spending in the US and elsewhere in the world. If US consumption collapses, the US trade and current account deficit will be halved and will lead to a drying up of global liquidity. I have discussed this relationship many times in the past and have clearly shown the relationship between the growth rate in Foreign Official US Dollar Reserves and the US dollar. Declining US consumption will be positive for the US dollar and will certainly bring down commodity prices because of lower demand (at least temporarily). But if you really think that such an outcome will be good for stocks, then dream on!

Finally, since the bull market in commodities began, there has been a body of people who have maintained that commodities are not an asset class. Some have even gone as far as to compare gold to washing machines. But consider the following: my dogs and my books are an asset for me, but maybe not to someone else. My dogs protect my house and my books. My books give me pleasure and – so I hope – some modest knowledge. But my dogs would be a liability to someone else if he lived in a secure condo building. (If there is such a thing as a secure condo building!) Also, my books would be useless to an illiterate person, since he would not be in a position to read them. A high-calibre mathematician is likely to be an asset for James Simons of Renaissance fame, but a huge liability in a rescue mission on Mount Everest. Water may be a huge asset if you are lost in the middle of the desert, but it is not an asset when you are standing in the rain without an umbrella and waiting for a date to arrive. So, the first point to understand is that anything can be an asset for somebody at some time, and not an asset for somebody else at some other time. Normally, cigarettes are not considered to be an asset, but in prisoners’ camps during wars, in wartime in general, and in times of hyperinflation, they are an asset – in fact, they replace cash banknotes.

Now, if someone defines an asset class as something that provides a cash flow, commodities may by this definition not be an asset. However, what if asset markets such as equities, bonds, and cash (T-bills) provide a negative return in real terms (inflation adjusted)? The moment when money loses its purchasing power because real interest rates are negative, and because we need to deal with people like Mr. Bernanke, assets such as raw land, commodities, art and collectibles do become a store of value and, therefore, represent a desirable asset class. All I wish to say is that the term "asset class" is extremely difficult to define, and that at different times and in different situations certain things and certain skills become an asset, whereas on other occasions they are useless. But one thing all my readers should clearly understand: when the last ship leaves the port as the enemy approaches, the captain of that ship will accept one kilogram of gold from you to buy your passage. I doubt that he will accept CDOs, derivative contracts, bonds or, for that matter, stock certificates of Fannie Mae or Freddie Mac. (Maybe by then the captain won’t even accept US dollars, because their value could decline precipitously during the voyage.) I may add that, in the financial sector, the last ship may be about to leave.

In sum, I believe that in the next few years the returns from equities will be disappointing (short-term rallies aside), which could cause other asset classes (especially industrial commodities) also to come under pressure. When I look around, I find it hard to identify any asset that is particularly attractive at this point. Therefore, in the absence of anything that promises far superior returns, I am still happy to accumulate physical gold. In democracies, where the leadership is afraid to ask for sacrifices from its citizens and with money printers at central banks, gold would seem to be the only sound currency.


Dr. Marc Faber
for The Daily Reckoning
August 6, 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.

"Fed keeps short-term interest rate at 2%", says today’s big financial headline. Stock market investors loved it. They bid up the Dow 331 points. "The correction is over," they seemed to say.

The Bernanke team knew it would be damned for sending the U.S. into recession if it raised rates. It knew too that it would be damned for allowing inflation out of its cage if it cut them. So it decided to do nothing.

"Although downside risks to growth remain," said a Fed spokesman, "the upside risks to inflation are also of significant concern to the committee."

Here at The Daily Reckoning headquarters we are fans of doing nothing – at least in financial matters. Not spending money, for example, keeps us from going broke. Not investing money often has the same effect. When it comes to money, politics or romance…the sins of omission may cause you to miss opportunities, but the sins of commission get you sent to Hell.

We’ve had our binoculars out for the last couple of days. What we’ve seen is a major correction. Initially, the correction was centered on housing and subprime mortgage finance. Then, it hit stock markets – doing most damage in the go-go markets of the emerging economies. And now, it is leaking into the rest of the financial industry.

"Defaults hurt credit card bonds," reports the Wall Street Journal. Morgan Stanley is said to "freeze client home equity loans," adds Bloomberg.

Everything gets corrected eventually. Total debt to GDP reached 230% in 1931. Total debt probably peaked out a couple of years earlier, but by the ’30s, GDP was falling, while the debt had yet to be liquidated – producing a record debt/GDP figure. Then, in the following correction, the ratio collapsed to 50% by the end of WWII.

But the last quarter century has been a great time to be in the financial industry. Everybody wanted to borrow…or to lend. The debt to GDP figure shot back up to near 300%…as the financiers collected their millions in bonuses. But now, another major correction is underway.

Commodities are correcting too. China announced a slowdown in manufacturing last week. This means less demand for oil, iron, copper and the whole complex of resources. So far, they’re down 10-20%. Yesterday, oil lost another $2.83, bringing the price down to $118 a barrel.

Gold, too, took a beating yesterday. It fell $21, to $886. "Will we ever have an opportunity to buy gold below $900," we asked a few days ago. Now we have our answer – yes. Will we have an opportunity to buy gold below $800? We will have to wait for the answer to that one. But our guess is ‘no.’ Because a bigger correction still lies ahead – a correction of the post-Bretton Woods, dollar-dependent, faith-based monetary system. Stay tuned…

*** We noted yesterday that the Dow stocks are losing money. Taken together, they no longer add value to the economy – they subtract it. The last time this happened, in 1932, proved to be a great buying opportunity.

But now we leave the facts for an opinion…and history for the future. Will 2008 prove to be a great buying opportunity in stocks? We doubt it. Stocks traded as low as 4 or 5 times earnings in ’32 – because the bull market prices had been corrected. Once knocked down, they could get up and dust themselves off. The difference today is that the stock market hasn’t been knocked down yet. So, it can’t get up – it’s already up. In an earlier, less optimistic age, the collapse of earnings caused a selling panic that made stocks cheap. Now, after a quarter century of rising prices…and an almost religious faith in the Federal Reserve…people read the financial news as though it were the summer weather forecast. Yes, it may be cloudy today, but soon the bad weather will pass and it will be sunny again. Stocks are still expensive.

What investors don’t realize is that the seasons change too.

Our guess is that a few pages have been turned on the monetary calendar too. The dollar has seen fairly decent weather since March. "The worst is over," say the fair-weather forecasters. "It’s clear sailing from here on," they guess. Then, looking at the decline of gold: "See, I told you so," they say.

But here at The Daily Reckoning, we treat our dollars like we treat our salads: there’s no sense in saving them. Not that we have a prejudice against the greenback. We feel the same way about the euro. And the pound. It’s all funny money as far as we’re concerned. In a correction, the real cost of things goes down. Because there are fewer people with the desire and the means to buy them. So, we’d expect the price of gold to go up – since it must become more valuable compared to the things it will buy. That is what happened in the Great Depression; Franklin Roosevelt first confiscated all the nation’s gold and then he raised its price 60% – effectively increasing the money supply the same amount.

Paper currencies, meanwhile, are created and managed by people who have a deep loathing for corrections of any sort. These are the people who set the U.S. government on course for a half a trillion dollar budget deficit this year…and who stand ready to spend $300 billion to bail out America’s over-confident mortgage lenders and over-stretched homeowners. They want to prevent a serious correction in the worst possible way. What’s the worst possible way? Ben Bernanke has already described it. He said he would "drop money out of helicopters" if that is what it took.

We don’t expect to see it raining $100 bills anytime soon. But we don’t expect any serious effort to contain inflation either – as evidenced by the Fed’s decision, yesterday, to do nothing. Instead, one way or another, they will do what Roosevelt did; they will lower the price of the dollar.

"Inflation accelerates; growth stagnates," summarizes Bloomberg.

The country should be listening to the "inflation alert," says the Wall Street Journal.

The latest official tally puts consumer price increases at 5%. But the Dallas Morning News issues a word of caution:

CPI numbers "may not reflect your family’s reality."

Inflation is on the rise; it will get worse. As it gets worse, the dollar will fall against gold.

*** Freddie Mac’s main man is in the news. The captain is being attacked for his role in steering the titanic mortgage lender. This from the New York Times:

"Richard F. Syron, in 2004 received a memo from Freddie Mac’s chief risk officer warning him that the firm was financing questionable loans that threatened its financial health.

"Today, Freddie Mac and the nation’s other major mortgage finance company, Fannie Mae, are in such perilous condition that the federal government has readied a taxpayer-financed bailout that could cost billions. Though the current housing crisis would have undoubtedly caused problems at both companies, Freddie Mac insiders say Mr. Syron heightened those perils by ignoring repeated recommendations.

"In an interview, Freddie Mac’s former chief risk officer, David A. Andrukonis, recalled telling Mr. Syron in mid-2004 that the company was buying bad loans that ‘would likely pose an enormous financial and reputational risk to the company and the country.’

"Mr. Syron contends his options were limited.

"’If I had better foresight, maybe I could have improved things a little bit,’ he said. ‘But frankly, if I had perfect foresight, I would never have taken this job in the first place.’

"Those and other choices initially paid off for Mr. Syron, who has collected more than $38 million in compensation since 2003.

"Now, some outsiders are saying that Mr. Syron and the top executive at Fannie Mae – some of the highest-profile figures in the business world – should be replaced."

Replaced? The poor man will also be harassed by the press and probably hounded by lawsuits. A hanging would be more humane.

*** How’s the war on terror going? We don’t hear very much about it. But it’s the justification for hundreds of billions of spending, not to mention wire-tapping, Guantanamo and water-boarding. You’d think we’d hear more reports from the frontlines…about the battles and casualties. Why not? Maybe no one really cares. The Pentagon has its money. The feds have their new powers. Maybe nobody really thought that terrorism was much of a threat in the first place. Here at The Daily Reckoning, we always considered it just a bugaboo. This just in:

"Study Criticizes ‘War on Terror’; Calls for Law-Enforcement Approach

"The publication of ‘How Terrorist Groups End’ – a thorough new report by RAND, a think-tank with historic ties to the U.S. military – vindicates critics of the ‘global war on terror’ who have argued that a law-enforcement approach to fighting al-Qaeda, rather than a military war, with all the bluntness that wars entail, would have been better for protecting Americans. ‘The report concluded that the administration’s war on terrorism has not significantly degraded al-Qaeda and that the group has morphed into a more formidable enemy,’ writes Ivan Eland, Senior Fellow at the Independent Institute and director of the Center on Peace & Liberty."

Until tomorrow,

Bill Bonner
The Daily Reckoning

The Daily Reckoning