You Can't Make This Stuff Up

In today’s column, I’d like to share with you a few ideas I presented at the recent Agora Financial Investment Symposium in a speech titled You Can’t Make This Stuff Up. I called it that because it’s hard to fathom serious people writing lines like this:

The renewed willingness and confidence to spend money we don’t have is vital to the continuing recovery.

That gem comes from The New York Times. Unfortunately, it reflects a common opinion. When I read stuff like that, I think we are truly doomed. I mean, is this really that hard? Spending money we don’t have is what got us into this mess in the first place!

The US debt ceiling fiasco makes that clear. The US is bleeding money. Every month requires huge amounts of financing just to keep the lights on. So far, creditors have been generous in extending ever-greater loans to the US — by buying its debt — at very low interest rates. It clearly can’t go on forever.

When the game stops, you can say goodbye to whatever fragile recovery we’ve enjoyed since 2008 and expect rates to rise. Rising interest rates are death to equities, simply because as rates rise, investors demand a greater incentive to own stocks. Remember, everything in the market competes with everything else for the affection of investors.

To see how this works, look back to 1982. Then you could earn 15% on a Treasury bond. No wonder the price-to-earnings ratio of the entire Dow Jones industrial average fell to just 7 times in 1982. (The current ratio is about 14 times.) That was a bleak time, too, with a deep recession, bank troubles and raging inflation rates.

Our time is troubled too, and the value of the US dollar has taken a beating. Yet we have this from BCA Research, a highbrow firm for which people pay tens of thousands of dollars to receive analysis like this:

A weakening US dollar has served the economy extremely well: It has helped trigger an export boom, inflate corporate earnings, lift stock prices and avoid deflation — all without costing anything.

Yes, a free lunch! All we have to do is destroy our currency and we’ll be rich. It’s worked for Argentina and Zimbabwe, too, right? Of course not. Yet this idea persists, like a rash that won’t go away.

But this extends beyond the US. The fact is most of the world’s Western governments are broke. As governments reach to make ends meet, it will come out of the hide of the private sector.

For many of these governments, the situation is desperate. Another gem: The Russian finance minister told the Russian people they should drink and smoke more to help boost tax revenues. “People should understand,” he said. “Those who drink, those who smoke are doing more to help the state.” And the Irish finance minister said his ministry is considering selling T-shirts that read, “Ireland is not Greece.” As I say, you can’t make this stuff up. Maybe Italy will hold a bake sale to help raise money!

Seriously, though, the list of the negatives out there is very long, and I could write this whole issue about them. Of course, outside of these issues, things look great! Let’s let former Fed chief Alan Greenspan sum things up:

There is no question that the momentum of this economy, leaving out the oil price issue, leaving out Euro problems that have emerged and very specifically leaving out the budget problems, this economy is really beginning to pick up momentum.

Ha! Yes, if only we could leave those things out. Unfortunately, we can’t, because we live in the real world. But the list is longer than Greenspan knows.

As I warned in last month’s letter, all is not well in China. It’s starting to slow down. We just got the latest figures for Chinese manufacturers in July, which were lower than June. This marks four months in a row of slowing growth.

This is in keeping with the nature of things.

There are booms and busts. What is unnatural is how long China has gone without a serious crisis. People seem to take it for granted that China will always be growing, pulling the global economic sleigh through the muddy patches. (Much in the way that people thought housing prices would never go down.)

A China contraction is something no one expects. And it would devastate many emerging markets (and even a few developed ones). This is a big concern because the bright spots in the global economy post-crisis were the emerging markets. Many of our best performers were companies with direct exposure to these markets, which allowed them to overcome a sluggish recovery at home and report good earnings.

But now China — the biggest driver of these emerging markets and the biggest buyer of a long list of commodities — is having some problems. As it slows, you can already see the ripple effect in some of the other emerging markets.

For example, I’ve warned about Brazil and what I called the coming “Caipirinha Crisis.” Brazil’s Bovespa — sort of like a Brazilian Dow Jones industrial average — is 20% off its November high as I write. It’s the first of the world’s 10 largest markets to fall into bear market status since Japan’s nearly did after the tsunami disaster.

In fact, as I pen these words, only two of the largest 16 emerging markets are up — South Korea’s Kospi and the Russian MICEX. In developed markets, only Germany’s DAX is positive, excluding the US — which isn’t up by much. A bad week and US markets could easily slip into the red for the year.

It’s getting ugly…and could get much uglier.

So how we do invest? What do we do in an environment like this? These were the questions I heard most often at the conference.

I have some ideas and some strategies, which we’ll develop further in my newsletter, Capital & Crisis, over the next few months. Our analysis may force us to make some changes to our portfolio and our thinking as we adjust to the new realities. It may be hard to do, but the best moves usually are.

The good news is that in every market, there are pockets of opportunity. In every market in history (even bad markets), there have been stocks that, looking back, you wish you had bought. In other words, in every crisis there are opportunities waiting to be found. Given the length of this year’s “you can’t make this stuff up” list, a mere fraction of which I’ve shared in this column, I expect we’ll have more such opportunities this time around.


Chris Mayer,
for The Daily Reckoning

The Daily Reckoning