JIM PUPLAVA: Well, here we are at the beginning of the year, and as we always do at the beginning of the year, people are looking for predictions, and especially with all of the volatility and unpredictability of the markets. But just like the polls in the United States, which seem to be missing out on things, it’s getting more difficult to predict.
Joining us on the program this year is Dr. Marc Faber, he’s the editor of The Gloom, Boom & Doom Report.
And Marc, I want to start out with something you said in your January newsletter, and you quote Lao Tzu, the 6th Century Chinese poet, where he said: Those who have knowledge don’t predict; those who predict don’t have knowledge. Isn’t this going to be one of those difficult years to predict where the markets are going? It just seems like there are too many crosscurrents this year.
MARC FABER: I don’t think that it is all that difficult to predict markets, but we have to understand that you can’t give a target for, say, the Dow Jones because you essentially have a manipulated market. Manipulated by the Federal Reserve, in the sense that if the Fed cuts interest rates to say zero percent or one percent, as they’ve done after 2001, then stock prices can be supported. But obviously a cut of interest rates at this stage of the cycle where we clearly have inflationary pressure would obviously increase the rate of inflation and probably weaken the dollar further – certainly against a hard asset such as gold and other precious metals. So let’s say someone said the Dow will go up to, oh, I don’t know, double. Say for argument’s sake, from 13,000 to 26,000. We would have to measure that increase –this doubling of the Dow Jones – in a hard currency such as either a foreign currency or in gold. And if the Dow doubles because of money printing by the Fed to 26,000, it wouldn’t mean necessarily that economic conditions improved, but it would mean maybe that inflation picked up dramatically and that the gold price goes up three times. [2:52]
JIM: You also quote Peter Bernstein the economist and strategist and he said that:
The current scene bears no resemblance to a typical economic peak or to conditions usually preceding a slowdown in business activity. Those kinds of conditions feature excesses in the business sector. But the business sector at the present time has a relatively clean bill of health. There are no signs of the usual boom in capital spending that leads to a cyclical top and leaves an overhang of capacity.
I’d like to get your thoughts on the current condition of business. Is this the one saving grace that we have in the US economy right now?
MARC: I think that it is difficult to say that we don’t have, let’s say, excesses in capital spending because we live in a globalized world. In other words, capital spending may not have been excessive in the United States – although I could argue that home building is some kind of capital investment; the whole commercial real estate market is some kind of capital investment. And what we have is we have excesses in capital spending in other countries such as in China and in other emerging economies. So basically, the US has outsourced largely it’s production, and that’s where the excesses in capital spending are occurring.
Moreover, in a business cycle you just don’t only look at capital spending. I think the biggest excess was in consumption in the United States, where consumption as a percent of the economy has increased from around 60% in 1980 to now over 70%. So in an economy where you essentially have maladjustments as a result of easy monetary policies the excesses do not necessarily have to be in capital spending. The excesses can be in asset markets, such as the housing market, in stocks, in commodities and they can be in consumption. [5:04]
JIM: Let’s talk about consumption, because the big question everybody has here –and there is such an emphasis in the US economy on consumption – and that’s the US consumer. And we’ve got a situation now where you know they can’t take out money out of their mortgages like they used to and use them as an ATM machine. We’ve seen a bit of a slowdown in the fourth quarter with consumer spending. Do you think this is the time that the US consumer finally goes on hold. I mean, they’ve been counting the US consumer out for years and decades, but it’s like the Energizer Bunny: They keep on spending.
MARC: Yes, I agree that there has been a lot of let’s say apprehension about the ability of the consumer in the US to continue to consume, but I think the important question here is the Federal Reserve and also the Treasury have encouraged, in the US, consumption. And does consumption lead to the creation of wealth? Or if you have a table full of food and you just eat the whole food away does it lead to a reduction of wealth? That is really the issue here. And I think that in the US the excessive consumption which was driven by asset markets, in other words by increasing asset prices – stocks until 2000, and after that by the real estate market – have essentially led to an economy that is starved [of] savings and starved of capital spending and characterized by excessive consumption which is on evidence from the growing trade and current account deficits. And now the goldilocks apostles they will always say, “well, the trade and current account deficits do not matter.” But they do matter in the sense that there has been a huge transfer of wealth to foreign countries, and now foreign countries have these sovereign funds which they invest globally; and there has been a huge creation of wealth, in particular in the resource-producing countries; and also there has been extended US dollar weakness. And so the current account deficit and the excessive consumption does matter to some extent for the well-being of the US. [7:33]
JIM: One thing that we’re starting to hear in the US, we’ve heard it from Hank Paulson and the President in December (we’ve seen it recently – the White House convened last Friday), they’re talking about some kind of stimulus package coming out from Washington. Whether it’s going to help people that are under duress right now because of mortgage resets – but some kind of fiscal spending program – who knows? Maybe we get some kind of helicopter drop. What about the US government combined with fiscal stimulus and monetary stimulus as it appears right now that the Fed is probably going to get more aggressive in its rate cutting.
MARC: Yes. I’m sure that they will implement a stimulus package, but I think the stimulus package will be an ill-fated attempt to revitalize the economy. If you look at the problem of the economy, it’s been excessive credit growth that came from easy monetary policies. And what they want to do now is essentially to implement another set of monetary policies and other measures to stimulate consumption, when consumption precisely has been the problem of the United States – the excessive consumption. And I think a stimulus package may be useful if it were directed at the stimulation of capital spending and at the encouragement of saving at the expense of consumption. And that can only lead to essentially a readjustment period in the economy. Readjustments – basically what the US needs is a recession. And only a recession can redress the excesses that have taken place. And if you superimpose another bubble on the existing bubble you create more maladjustments in the economy and more ill-fated measures that eventually lead to a total breakdown of the system. [9:42]
JIM: You know, unfortunately here in the US, whether you’re watching both parties – the Republicans or the Democrats – they’re talking about ways to increase consumption because they’re worried by a slowdown in consumer spending. And nobody in a presidential election year seems to want to take the pain to go through a recession and redress a lot of the imbalances or cleanse the system because of the imbalances we see right now – whether it’s mortgages, excess consumption and indebt[edness]. So in the end, could you see a scenario, Marc, something like this: In the first quarter we see economic weakness as we’ve been seeing, we see more write offs coming from the financial system (there’s talk about Citigroup maybe writing off $16 billion), also there’s going to be a slowdown in corporate earnings, and then we get a massive response from the Federal Reserve that temporarily probably stimulates the markets. So let’s say, in between, if you think of an Oreo cookie, a hard first quarter, a creamy filling in the second and third, and by the fourth quarter higher interest rates and inflation come back to bite us again.
MARC: Well, personally, I think that the US, if you measure economic statistics properly –and the government is lying blatantly – the US went into recession 3 months ago. And I’m saying the government is lying blatantly, because they take nominal GDP and then they fiddle around with inflation figures. I mean none of your listeners have an inflation rate of less than 5 to 6% per annum. You just can’t exclude food and energy prices and healthcare costs from the CPI, from the cost-of-living increases. So nominally the US economy may still be growing, but inflation adjusted –in other words, in real terms – we’re already in a recession. And most US households, except for the super rich, are today no better off than they were five or seven years ago. Their income gains have all been eaten up by cost increases by inflation.
Now, some people have benefited from asset inflation in the sense that their houses in which they live have appreciated in value but that has been precisely because of easy monetary policies and the debt growth that have now brought about problems.
And all I can say is that corporate profits in my opinion began to contract in the third quarter of last year and they will continue to contract, because corporations now –and this is important to understand – corporations are facing cost increases. So the margins are going to be squeezed. And whereas the valuation of the stock market is not unbelievably high in the sense that stocks are not selling at 50 to 80 times earnings like in Japan in 1989, if you exclude say the energy sector from the S&P which is selling at 12 times earnings or 10 times earnings, then the S&P valuation is over 20 times earnings. If you’re faced with declining earnings then basically the S&P is not a great bargain here. [13:14]
JIM: Let me just continue on that inflation theory, because what you are talking about in the fourth quarter the GDP deflator, if I recall, was falling from the second, third and fourth quarter last year; and I know in the third quarter the GDP deflator was the lowest since Eisenhower was president. So could you get statistically, and I’m just looking forward in an election year, maybe we get the lowest inflation rates since Calvin Coolidge was president. So in nominal terms as reported by the government we get this slow growth figure that they’re talking about – one to two percent – in those terms, we avoid a recession even though in real terms we are in one.
MARC: Well, basically, that would be a form of stagflation. And I mean it’s very difficult to measure GDP in the first place, and what you have to look at is essentially standards-of-living increases in an economy. And I don’t think that there are many standards-of-living increases in the United States at the present time, nor for that matter in Western Europe. We have huge standard-of-living improvements in emerging economies where a middle class is being created and where even workers or farmers are doing better than say a couple of years ago. But my point is simply that the government is lying. And they will continue to lie because they don’t want to admit that they created an unbelievable economic mess. Nor will the Fed admit that their ill-conceived monetary policies led to the crisis that we have today in the financial markets. [15:01]
JIM: What about the theory that’s being bandied about, even though the US economy slows down as we are now seeing that –they call the decoupling theory – that the rest of the world (whether it’s Europe, Asia, emerging markets) will continue to be strong? So therefore, if you are let’s say a large cap international company where you get a good majority of your sales overseas – and a good example would be, for example, DuPont this week beat estimates. They get 60% of their business overseas and because of that business doing very well their earnings were higher than expected. Do you subscribe to the decoupling theory, or do you think a slowdown in the US will have some effect on Europe and the rest of the world?
MARC: Well, basically, we have to first of all distinguish between an economic decoupling and a financial decoupling. In other words, can some countries grow when the US is say in a no-growth mode or in a recession mode? I think that this is possible because if you look at basically the US economy over the last two hundred years, occasionally you had a recession in one state, say, Texas in the early 1980s (when the oil price started to go down), and you had expansion in another state like New England (which benefited from lower oil prices); or in the early 1990s, you had a recession in California but other states they were expanding. So in an economy which is very complex, where you have different regions and you have different sectors – industrial sectors and service sectors – it is conceivable that one sector is in recession and other sectors or other regions are not; that is entirely possible. But I would argue that over the last seven years we had an unprecedented global economic boom where essentially every country has been growing with the exception of Zimbabwe, because you have a money printer in Zimbabwe who essentially should be joined by Mr. Bernanke. He would fit very well with Mr. Mugabe in that country.
Now, what happens if the US no longer grows is that the trade and current account deficits of the US shrink. In other words, we had during the excessive consumption period 1998-2006, a current account deficit in the US that increased from 2% of GDP to over 7% of GDP, and at the end was supplying the world with $800 billion annually. And this river flows into the world through the American current account deficits, and essentially provided the world with the so-called excess liquidity and created booms in everything from art prices to commodities, stocks, bonds, real estate, what not. And once the US no longer has this growing current account deficit, but a shrinking current account deficit, you have essentially a relative illiquidity coming up in the world. It is not that it’s tight money, but the rate of growth of liquidity shrinks and it does have obviously an impact on the economies and on the asset markets. And it is conceivable that say the US goes into a recession, Europe goes into a recession and that China does not go into a recession but into a growth slowdown, say from 8 to 10% GDP growth down to 3 to 6% of GDP growth. But this decline in the growth rate is still very uncomfortable for China, as well as for India. So I’m not a great believer in this decoupling theory.
Moreover, I don’t believe that financial markets will be decoupled. In fact, I would argue: If you look at look at the last four years, 2002 to today, then emerging markets have been the big bubble. The US markets have not been a gigantic bubble in the sense that US equities, especially large cap stocks, are not terribly expensive by world standards because the dollar has gone down so much. And so the big bubble is probably in emerging markets; and these markets, obviously if the S&P goes down, will be hit very hard. And I would argue, if someone puts a gun to my head, and says, “Marc, you must buy stocks,” as much as I dislike saying this but I would probably rather buy US stocks today, than say some of the emerging markets that are selling at 30 to 50 times earnings. [20:08]
JIM: You bring up an interesting point about liquidity in the world which has a genesis in much of the US trade deficit. As we look around the globe today, Marc – I have a screen on my Bloomberg that has year-over-year money supply growth rates around the globe and what is surprising as I look at this table is to see double digit money supply growth around the globe out of 18 of the top 20 central banks. I think Europe reported last week it’s money supply is growing at over 12%, yet Trichet is talking about being tough on inflation. You know, the inflation rates that we’re seeing here in the United States, are they not global in nature? Are you finding that, for example, in China where you have the inflation rate going at 6 or 7%, that this is a global phenomenon?
MARC: Yes, I mean that’s the point. I mean when recently people were very negative about the US dollar and so forth – and of course, long term you cannot be optimistic about the US dollar – but the US dollar has declined quite substantially, especially against the euro in the last couple of years; and the Europeans are also good money printers. It’s not just Mr. Bernanke that is the chief money printer. The others are not much better either. So basically, you have this excess liquidity being created in order to support asset markets and so forth.
But the point about this excess liquidity is that an eternal boom is out of the question. So what the Fed and the other central banks can do is kind of stimulate, through easy monetary policies, credit growth; but the private sector if it becomes, say, risk adverse can withdraw liquidity and a) not lend and people can also refuse to borrow, and so the credit does not accelerate but actually contracts. And that leads to what I call a relative illiquidity (it’s not an absolute illiquidity, it’s a relative illiquidity) and that then has some negative implications on some asset markets. But to come back to the first question you raise about making predictions, I think the difficulty today is that under normal conditions, say under a gold standard, we would be in a massive deflationary recession at the present time. Now, the central banks are all intent to prevent that and they print money like crazy and throw liquidity at the system by cutting interest rates and taking extraordinary measures. And so the question arises: How did you measure really economic growth and how do you measure your wealth? Say, as I mentioned, if the Dow goes from here to 26,000 – it doubles in value – if at the same time the gold price goes up 5 times, you lost out by being in financial assets. And I think this is what has happened since year 2000. In year 2000, as you know, you could buy with one Dow Jones, 44 ounces of gold. And now you can buy less 15 ounces of gold.
Now, I’m not saying that gold cannot have a meaningful correction, but I think that the central banks have created actually a state which I would almost call a hyperinflation where asset prices go up very substantially and they don’t make you really richer. I mean say in 1980, there were six billionaires in the world, and today you have thousands of billionaires in the world, everywhere. And money – the value of money – the purchasing power of money has depreciated very considerably. And I’m not speaking here of the US, because I was recently in New York and I saw that the price level in New York is actually quite reasonable compared to, say, the price level in Europe and in other countries. But usually when you have a situation like the US that has achieved relatively low prices levels through currency devaluations – and the US has pursued a policy to lower the value of the dollar – what usually follows (and not every time – usually what follows) is high and accelerating inflation rates. And the US government of course they will understate inflation, but the pocketbook of the consumer will notice this increase in inflation and what you will then get is essentially prices going up and the standards of living of people going down – in other words, stagflation. [25:08]
JIM: Isn’t this one of the signals that gold is giving to the financial markets? When you look through this period of time where we have seen nominal increases in assets and stock markets around the globe, yet if you look at the summer of 2001 when gold was at 255, and here we’re looking at gold heading towards $900 – do you think this is what is being recognized around the globe, that everybody knows that money is dying, it’s losing its value so gold is becoming the ultimate currency to hold?
MARC: Basically, my view is this: Normally, the safest investments in a society is cash, deposited in a bank or in Treasury bills. But the Western democracies and governments in general have created over time an environment where actually cash is a disastrous investment because you’re losing out to inflation like in the 70s as a result of consumer price increases or in the last couple of years as a result of asset price increases. Now, I’m not suggesting that there cannot be times – three months, six months, one year – when cash does better than, say, stocks or better than real estate. Say, in the last nine months it was better to be in cash than in stocks that depreciated or in real estate that depreciated. But basically, if you print money like the Fed or other central banks do, the value of money – of paper money – goes down and then it’s reflected in an increase in the value of assets such as gold that cannot be multiplied at the same rate. I mean someone could say, “oh, the gold price has gone up a lot since 2001.” I can turn around and say: “No, the gold price is the same. It’s the dollar the dollar that has collapsed against the price of gold.” And why did the dollar collapse against the price of gold. You call up Mr. Greenspan and Mr. Bernanke and you ask them about it. Of course, they will never give an answer. Each time Ron Paul asks them a sensible question they just evade the question and they move on to something else because, as I explained, they are a bunch of liars. And actually, if there was a court for honest money, both Mr. Greenspan and Mr. Bernanke should be hanged. [27:44]
JIM: You know, it was interesting – you mentioned Congressman Ron Paul. The last time Bernanke was on Capitol Hill, he asked him about curing inflation with more inflation, and asked him about what was happening to the dollar. And Mr. Bernanke responded – which I was horrified – and he said, “well, actually if you live in the United States and you pay for things with dollars it really doesn’t affect you.”
MARC: He’s out of his mind. Go to Zimbabwe and ask the citizens there: If you pay in Zimbabwe dollars it affects you that the currency has collapsed? Of course it affects you.
JIM: There’s a situation I want to move on to in the financial markets. A lot of the risks that we’ve seen erupt last year, whether it was in February with intermediate lenders or August with the collateralized debt obligations, something that has not gotten much attention and I think could even be a bigger issue and that is credit default swaps, which are now estimated to be somewhere in the neighborhood of 45 trillion. I think there have been a lot of people, Marc, in the hedge fund community and the banking community during this period when we were inflating between 2003 and 2006, they were writing these credit default swaps on corporate bonds because it was almost like free money. Now, if the US economy has gone into a recession –even though we’re not saying it formally – when you go into a recession companies have greater difficulties making their earnings, earnings slow down, cash flow slows down. And what happens if you start getting a bunch of corporate bond defaults? I think this is an issue with these credit default swaps that nobody is looking at. A few people have talked about it; Bill Gross saying it could be somewhere in the neighborhood of $250 billion losses. This is another issues that could surface this year that could throw chaos into the markets.
MARC: Well, I think you’re touching on something very important. I think that over the last 25 years we had numerous financial innovations. And I have to say is, the Federal Reserve had the power to control the financial innovations but actually they encouraged it and led to the excesses we had recently. And I think that the problem that occurred in subprime lending is a symptom of a much wider problem, and that the subprime lending crisis infects obviously other credit markets and so forth and that it will spread like a bush fire through the economy, especially if an economy was essentially driven by excessive credit growth. I mean in the last seven years GDP increased by $4.2 trillion and total credit between 2000 and 2007 increased by $21.2 trillion. In other words, debt has been growing much faster than the nominal GDP.
And I think that now we are in a process of deleveraging – of credit contraction, basically – but the Fed and the Treasury will do everything to restimulate the credit growth that led to the problems in the first place. That’s why I’m arguing that the policies of Mr. Greenspan, of Mr. Bernanke and Mr. Hank Paulson are totally misguided. Totally. And I believe, you know, the financial stocks, every bull market I’ve seen since 1970 when I started to work was accompanied by strength in financial stocks. When you have weakness in financial stocks something is wrong. And therefore, I don’t believe that this bull market that we had since October 2002 to the Summer of 2007 that this will come back. I rather believe that we are in a period of high volatility like in the 70s, when the Dow moved up and down every year by 20%, and in 1982 the Dow was still no higher than we were in 1964. So I think we can have a lot of fluctuations here. And at times the Fed, through rate cuts, can manipulate equity prices higher and so forth. And at times we will have disappointing earnings, disappointing results. And I would suppose that we will have massive bankruptcies as well where financial firms become illiquid and insolvent and are forced to the wall. And so the market environment for financial assets is not going to be particularly good. [32:46]
JIM: Let’s talk about a couple of investment themes among this volatility that we’re seeing. A couple of things that stand out or strike me, Marc, is energy which has been on a roll – and I happen to subscribe to the peak oil theory. I mean we have not made any major discoveries, we’re not replacing what it is that we consume, we have more people consuming energy today. That is one theme that I can see. And along those lines and something similar – you cover this in your current newsletter – is you’ve got a little over 1% population growth in the world, the acreage for growing crops isn’t expanding. In fact, in certain areas like China it’s being turned into parking lots – like Joni Mitchell’s song – or buildings. What about the theme of energy, food and precious metals if you wanted to be in this market as a long term investor?
MARC: Yes, I think that’s a very good point. In general, I believe that you should be in assets that cannot be multiplied easily, such as commodities (whether it’s copper or zinc or nickel or oil or precious metals), or food items (wheat, corn, soybeans, sugar and so forth). But the commodity markets had a very big move and the price of oil has gone up essentially almost 10 times since 1998 from $12 a barrel to now close to $100 a barrel. And in an environment of slowing growth in the world, I would be somewhat careful of investing now in industrial commodities whose demand depends essentially on strong economic growth. So I would not be surprised to see – as has already happened in some commodities like nickel – that prices correct meaningfully. And all I can say to investors is I’m bullish about gold in the long run, but don’t buy anything –whether it’s a house or stocks or precious metals – if you are not prepared to ride through say a 20% correction, because we have higher volatility. We will get more corrections along the way up. I mean I remember the great bull market of the Taiwanese stock market, 1984 to 1990. The market went from an index of less than 500 to 12,500, but we had in 1987 a 50% correction, in 88 a 40% correction, in 89 a 30% correction until we reached a final peak. So investors have to get accustomed to higher volatility. And someone who cannot live with this volatility because he is leveraged, is going to be forced to the wall.
So my advice is to be prudent. And yes, I like energy. I think energy stocks are actually quite inexpensive. But if the oil price for one reason or another drops to say $70, then obviously energy stocks will be down. And all I notice is when I started to like commodities in the year 1999 to 2002, it was not a widely accepted investment theme. And today, the investment theme is much more well known, and there are many more speculators in the market place. So I’m still positive in the long run but cautious say for the next six months. And I would also add, as of today – you see, if I remember, well, in 1980, after 10 years of consumer price inflation in the US, everybody thought that consumer price inflation would continue forever. And what then happened after 1980 is that consumer price inflation slowed down and we had a period of disinflation. Today, if there is one consensus it is that paper money will become worthless and that asset prices will continue to go up. And I would still think that it’s not very likely that Robert Prechter is going to be right with his deflationary bias –with everything, with gold prices collapsing to the Dow going down and so forth – but I would still think that there is still a small probability that we could have actually a period of deflation in the near future, which then will lead the central banks to print money like crazy. But in this period of deflation that I would not rule out we would have big declines in asset markets – big declines. [38:09]
JIM: Let’s say we start to get deflation. I mean certainly we’re seeing falling housing prices in the US and other places of the world. Do you think that we get preemptive strikes and perhaps they just throw all caution to the wind? Like right now, the latest consensus is when the Fed meets January 30th it’s going to be 50 basis points; and there’s even talk within the markets that they don’t wait until January 30th if things begin to deteriorate. I know there’s a lag effect to all kinds of things, whether it’s raising interest rates or lowering interest rates. If this deflationary period that could possibly erupt, do you believe it would be short-lived?
MARC: Yeah, very good question. I am quite sure the Fed will cut by 50 basis points; and if not by 50 at least by 25. But as you know, in Japan they cut rates dramatically to essentially zero and we still had deflation. I mean we cut interest rates from 6.5% on the Fed funds rate in January 2001, to 1% in 2003, and yet the NASDAQ still went down. So whether interest rate cuts and even a stimulus package – fiscal package – will help much remains to be seen. We could be in an unusual situation where it doesn’t help much. It’s possible because the public or the household suddenly starts to save; in other words, the savings rate goes up and people become risk adverse. As I said, I don’t know how the world will look like in a year’s time. I’d rather be in gold than in the Dow Jones, whereby maybe for the next three months the Dow Jones could outperform gold for a while. But in general, it’s very, very difficult to make any kind of predictions that make sense simply because you don’t know how irresponsible Mr. Bernanke and Mr. Hank Paulson will be. We just don’t have any idea. As you say, they can do a lot of things to try to support the asset markets. And Mr. Bernanke has written and spoken about this: that you cannot identify bubbles but when they burst you should step in with extraordinary measures. We just don’t know how extraordinary his measures will be. I mean the best for Mr. Bernanke, the best extraordinary measure would be to resign and say: “We failed. We are incompetent.” [40:54]
JIM: But you know, Marc, if you take a look at his study of the Great Depression and people might recall the comment he made at Milton Friedman’s birthday where he said to Mr. Friedman: “You know, you were right, we made the mistake. We caused the Great Depression. I assure you, it will never happen again.” Basically saying, according to Mr. Bernanke’s view and study of the Great Depression, the reason we had it was the Fed didn’t print enough money. Had they been able to do so the Depression would never have occurred. So it almost gives you an insight in terms of his thinking, which is along the lines with Mr. Greenspan in the sense that anytime there’s a problem in the economy or the financial markets massive liquidity seems to be the response and answer.
MARC: Yes, that is correct and I’ve written about this. And I think that the entire analysis of the Great Depression, especially by Mr. Bernanke, is totally wrong. The causes of the Depression were not tight monetary policies by the Fed, but easy monetary policies by the Fed. And Paul Warburg, who was at that time a Fed member, later on commented about this; that the Fed should have pursued tighter monetary policies in the years leading to 1929. And I’d just like to mention one point: In 1929, the PE on the Dow Jones was just about 13 times earnings. We didn’t have a massive stock market bubble in terms of valuation, but what we had is an earnings bubble and half the earnings collapsed. And I think today we don’t have, you know, like 50 times earnings on the stock market like we had in Japan. But I think we have an earnings bubble and that the earnings will disappoint very badly. But I’m just convinced that in a democracy, especially in a country like the United States, the politicians will print money. And whether or not it will always help to support asset markets is very questionable.
The one thing I can assure you is that money printing doesn’t create wealth. That is important to understand. And at some point, as my friend Barry Bannister pointed out, you reach with credit growth the zero hour. In other words, you print money, credit grows, but the economy doesn’t respond. And I think we are already in that situation. And what the outcome will be, hyperinflation or deflation, that is the difficulty to judge. But I think personally as an investor, I would be positioned to some extent in gold because in a deflationary environment I happen to believe that gold would outperform other asset classes because things will get so bad that people will run into gold as a safe haven. And at the same time, I would hold essentially some cash and I would probably deleverage. In other words, I wouldn’t hold a lot of debt in the present environment. If there is hyperinflation, to hold a lot of debt is the right thing to do; but just in case we have deflation, like now in housing and now probably also in commercial properties (that is the next shoe to drop), that in such an environment you’re better off by not holding too many debts. [44:40]
JIM: I want to cover a point in your January newsletter and just let our listeners know, if you don’t subscribe to Marc’s newsletter you’re really missing out on some good thinking.
MARC: Well, it is very kind of you.
JIM: You had a gentleman who has written pieces for your newsletter in the past, his name is Michael O’Higgins, he’s author of Beating The Dow – a very sharp money manager, and I’m going to quote from your newsletter here, and he goes:
So where does one find value in today’s investment world? In my view, given that the main focus of the current US Federal Reserve board remains one of fighting deflation, investors should avoid bonds entirely and concentrate on investments that can protect them from a rising inflation rate i.e. stocks and commodities. With these two categories we have our portfolios equally invested among four investment themes: dogs of the Dow; dogs of the world; precious metals and mining; and energy.
What do you think of that?
MARC: Well, basically, I agree with Michael and I think that if you buy today at 10 years the US Treasury, or 30 year US Treasury, you’re flirting with disaster because they will only perform well in an environment of total deflation, given the low yields they provide at the present time. But as I said, the concept of inflation and deflation is very complex because you can have an economic system where some assets are inflating and some assets are deflating. Like in the US, say in the last 12 months, you would have been better off in US Treasuries than say in the housing market, which has declined in value. So in general, I of course agree with Michael to be in stocks in the long run and to be in precious metals and in energy in the long run and so forth. I’m not sure whether that is the right medicine for, say, the next three to six months. I mean I’m very cash rich here. I’m cash rich US dollars. I think the US dollar does not have a significant downside risk against the euro. In other words, if you put a gun on my head and said, “Marc, you have to choose one currency today, for the next three months: the euro or the US dollar,” I think I would choose the US dollar. Although, I’m very negative about the US dollar in the very long run. But just for the next three months I think the dollar will hold because the current account deficit is now shrinking, the trade deficit is no longer expanding and so forth and so on; and the dollar is relatively inexpensive vis a vis the euro. Would the question be: put all your money into US dollars cash, or put all of your money in gold? As of today, that would be a very tough question because the gold market in my opinion is now somewhat overbought and could undergo easily a 10 to 20% correction. [47:59]
JIM: I’m sensing, Marc, as we’ve had this discussion and also from reading your newsletter, that you’re very cautious at this point. The fact that you’re holding larger amounts of cash and in the dollar is that because of the amount of uncertainty? And what would cause you to move out of cash?
MARC: Well, I think that as an investor – and I’m not a mutual fund manager or hedge fund manager that needs to show performance every week or every month – I’m a believer that occasionally the markets create an unusual opportunity. The unusual opportunity of the last 10 years was really commodities in the years 1999 to 2001, and emerging economies following the Asian crisis. They provided a lifetime buying opportunity. Now that the whole world is captivated with investments, and buying this and selling that and moving here and moving there and performance, I sometimes feel I want to actually be on the sidelines and just give it some time until I make the next major bet. I mean I’m involved quite heavily in gold. Would I put now all my money tomorrow into gold? I doubt it. And I want to be diversified. And all I can say: investment opportunities arise again and again. I mean, I suppose if Citigroup went down to $5, I’d be tempted to look at it. I’m not particularly interested here at the 27 to $30 level, because the financial excesses we had that were built over the last 25 years will take time to kind of correct. And if you have a boom sector, say, like the oil sector in the 70s, afterwards for 20 years oil was unattractive and the drillers were unattractive. And so financial stocks, after a bubble burst in that sector may not provide the leadership in the future and may be unattractive for many, many years to come. But I’m convinced, like I wrote about in my last report about Cambodia, I think there are some countries in the world whether it’s Cambodia or Ukraine or Belarus or parts of China or parts of India, or parts of Russia that can have strong economic growth even in a weakening global environment and provide investors with unusual opportunities. [50:50]
JIM: Marc, you do a lot of traveling around the globe and I think that gives you a different perspective than let’s say some analyst that stays in his office all the time. As you have been traveling over the let’s say last 12 months, is there anything that stands out in your mind and things that you’ve observed?
MARC: Well, I mean people talk about the housing bubble in the United States and the downturn in housing prices in the US. What stands out to me –and I never experienced that before and I’ve been traveling extensively since the 1960s – is wherever you go you encounter boom conditions. And some boom conditions are bigger than others. Say three years ago there was a boom in Dubai. Two years ago the boom was a bit bigger; a year ago it was a bit larger; and now, it’s difficult to imagine how the boom could become bigger to what it is right now. And the same happens in many other countries. Everywhere you have essentially a forest of cranes building; and we have an unbelievable construction boom everywhere in the world. And my view is simply: If you have a synchronized global economic boom as we have had, then the consequence is one day a global synchronized bust, because in the past usually booms were concentrated in one sector, say oil in the 70s or NASDAQ, I mean technology in the late 1990s, or Japan (1985-1990). So that was just one sector of the global economy that was booming and the others weren’t. But now I can assure you: Everywhere you have a colossal boom; and I think this will give way to colossal bust. If it’s this year or next year, who knows? But I don’t want to be caught in this colossal bust. And if someone says, “oh, we can make a lot of money over the next 12 months until it happens,” then good luck to him. I just don’t want to be overly exposed to this boom at the time when, say, cyclically I can see that there is this relative illiquidity coming up and where it is difficult to build much on the existing boom. And besides from that, if you really have boom conditions, that doesn’t guarantee that equities go up. Sometimes you have strong economic conditions and stocks go down like in the Middle East in 2006, early 2007. We had boom conditions but stocks still dropped 50 percent. [53:41]
JIM: Well, you know, Marc, I think it’s in the next week or so you meet with the Barron’s roundtable group. I’m sure I think your views are going to be much, much different than the roundtable. They usually are. Do you expect optimism to be expressed there. I mean one of the standard things that we see today, slow growth, rising markets, even though earnings are going down, interest rates are going down, so we could see multiple expansions. What do you expect your group of peers to be saying?
MARC: Well, basically, the interview took place last Monday and the group by and large is bearish on the economy. But they are in denial about the stock market. They all think that stocks will be okay, but they are bearish on the economy. And that’s what I think is happening throughout essentially the money management establishment. People are kind of cautious on the economy. The economists predict, say, a soft landing and the analysts are essentially actually quite positive because they predict the S&P earnings to grow by 12 percent this year. And so there is this environment of what I would call self-delusion. And my view is that the markets won’t perform well. But equally, as I said, if someone said you must own stocks, I think the emerging stock markets today are more vulnerable than the Dow Jones. And so if I had to own stocks, probably I would be in the Dow Jones – whereby I’d prefer not to own any stocks. [55:15]
JIM: Well, Marc, I want to thank you for joining us on the Financial Sense Newshour. You’ve been very generous with your time. I know it’s late there in Thailand where you join us. If our listeners would like to find out more about your work –and by the way, my compliments, it’s probably one of the best written newsletters out there. It’s always full of interesting aspects or thoughts on investing – tell them how they could do so.
MARC: Well, basically, they can send me an email at FaberDoom@yahoo.com, or they can go to the website www.gloomboomdoom.com.
JIM: Marc, I want to thank you so much for joining us on the program. I want to wish you a happy, prosperous and healthy new year.
MARC: Well, thank you very much for having me.
Guest Expert Page & Contact Information
Tuesday, October 21, 2008
Monday, October 20, 2008
Cold Water on Today's Bull
http://seekingalpha.com/article/100771-throwing-cold-water-on-today-s-rally-mark-faber?source=article_lb_articles
Saturday, October 18, 2008
Hedge Fund Not Fun Anymore
Investors pulled at least $43bn from US hedge funds in September as market turmoil led to unprecedented withdrawals, an analysis by a leading research house shows.
The data from TrimTabs Investment Research – which was to be sent to clients late on Wednesday – come as hedge funds are working to prevent far bigger redemptions by the end of the year, when many funds give investors a chance to take out money.
Withdrawals can lead to a vicious circle in the markets, as funds sell holdings to return money to clients, depressing prices and prompting further redemptions. ...
The chief executive of a leading alternative investment manager said he expected the hedge fund industry to shrink by 50 per cent in coming months – with half the decline coming from withdrawals and half coming from investment losses.
Conrad Gunn, chief operating officer of TrimTabs, said the $43bn in September withdrawals would mark “the beginning of what we expect to be a series of outflows for the remainder of the year. We expect October outflows to be larger”.
The industry, which manages close to $2,000bn, has experienced outflows during only a handful of months previously, including a small outflow in April of this year.
If you ask me what makes me most bearish, what makes me think that the S&P 500 could go to 600, it is not the recession. We have gone through recessions before, even credit-induced ones.
No, what makes me very worried and why I am not deploying capital just yet, even though the market is getting cheap, is the tsunami of hedge fund sales that may be on the horizon.
Recessions we have seen before. Highly leveraged fund liquidation by over-compensated money managers in an industry that gets paid not to take losses whose time horizon is next quarter and whose clients thought they would earn money in any market environment we have not seen before.
That is what worries me.
The data from TrimTabs Investment Research – which was to be sent to clients late on Wednesday – come as hedge funds are working to prevent far bigger redemptions by the end of the year, when many funds give investors a chance to take out money.
Withdrawals can lead to a vicious circle in the markets, as funds sell holdings to return money to clients, depressing prices and prompting further redemptions. ...
The chief executive of a leading alternative investment manager said he expected the hedge fund industry to shrink by 50 per cent in coming months – with half the decline coming from withdrawals and half coming from investment losses.
Conrad Gunn, chief operating officer of TrimTabs, said the $43bn in September withdrawals would mark “the beginning of what we expect to be a series of outflows for the remainder of the year. We expect October outflows to be larger”.
The industry, which manages close to $2,000bn, has experienced outflows during only a handful of months previously, including a small outflow in April of this year.
If you ask me what makes me most bearish, what makes me think that the S&P 500 could go to 600, it is not the recession. We have gone through recessions before, even credit-induced ones.
No, what makes me very worried and why I am not deploying capital just yet, even though the market is getting cheap, is the tsunami of hedge fund sales that may be on the horizon.
Recessions we have seen before. Highly leveraged fund liquidation by over-compensated money managers in an industry that gets paid not to take losses whose time horizon is next quarter and whose clients thought they would earn money in any market environment we have not seen before.
That is what worries me.
Thursday, October 16, 2008
Time will tell
Seth Glickenhaus, who in 1929 had just become a Wall Street Broker says that we are on the verge of a new bull market, within a week mind you, and there is no question the U.S. did the right thing.
::::::::
I suppose in this video, when Mr. Glickenhaus states that the U.S. "did the right thing" he is referring to this rapacious Wall Street bailout Bill?
::::::::
I suppose in this video, when Mr. Glickenhaus states that the U.S. "did the right thing" he is referring to this rapacious Wall Street bailout Bill?
Monday, October 13, 2008
A pure financial crisis?
chincook,
Though I never posted at mitbbs, I have been reading there a lot and like your posts the most. Glad to see you here. As for your view, I was thinking the same and still think it could be the best scenario if everything turns out the way as we hoped: a pure financial crisis. That's why I was quite bullish in the beginning of the year and shouted bottom around 1250, and worst 1150. Boy was I wrong, I would be chopped to thousand pieces if I posted that in MITBBS.
Not till the July crash, I came to realize how severe the situation is, we are talking about a 12 trillion Real Estate bubble, compare with 5 trillion Nasdaq 2000 melt down, it’s 2.5 time worse, in addition to that, We are living in a globalized era, globalization makes life better in many ways, but when it fail it could be quite ugly. As for how bad it can be, it is up to anyone’s guess.
On the bright side, the world will be much better after the wash off, there will be many prosper years ahead of us, so let’s get prepared for this to end, and end it will, that I can assure you.
chinook wrote:
头次开贴，上周四晚上和朋友们说的几句话：
“I have been thinking about this sell off with the 1929 one, and I still believe this will be a much short event, it might only have a quick dent for the economy, just like a flu. The quick response, coordinated actions across the globe and the real needs from emerging market will prevent a deep recession from happening. ”
基本的想法就是so far，实际上还是金融危机，如果政府开动印钞机器，很多程度上代理financial inst的功能，或让金融机构再次运转起来，那么经济主体当不会受太大影响。
向各位老大请教下，这个看法哪里不对？
Though I never posted at mitbbs, I have been reading there a lot and like your posts the most. Glad to see you here. As for your view, I was thinking the same and still think it could be the best scenario if everything turns out the way as we hoped: a pure financial crisis. That's why I was quite bullish in the beginning of the year and shouted bottom around 1250, and worst 1150. Boy was I wrong, I would be chopped to thousand pieces if I posted that in MITBBS.
Not till the July crash, I came to realize how severe the situation is, we are talking about a 12 trillion Real Estate bubble, compare with 5 trillion Nasdaq 2000 melt down, it’s 2.5 time worse, in addition to that, We are living in a globalized era, globalization makes life better in many ways, but when it fail it could be quite ugly. As for how bad it can be, it is up to anyone’s guess.
On the bright side, the world will be much better after the wash off, there will be many prosper years ahead of us, so let’s get prepared for this to end, and end it will, that I can assure you.
chinook wrote:
头次开贴，上周四晚上和朋友们说的几句话：
“I have been thinking about this sell off with the 1929 one, and I still believe this will be a much short event, it might only have a quick dent for the economy, just like a flu. The quick response, coordinated actions across the globe and the real needs from emerging market will prevent a deep recession from happening. ”
基本的想法就是so far，实际上还是金融危机，如果政府开动印钞机器，很多程度上代理financial inst的功能，或让金融机构再次运转起来，那么经济主体当不会受太大影响。
向各位老大请教下，这个看法哪里不对？
Sunday, October 12, 2008
Closer to the bottom
FOR THE TENS OF MILLIONS OF INVESTORS WHO HAVE been nervously watching the U.S. stock market's 40% decline in the past 12 months, and it's 18% drop in the past week alone, history holds some solace: There is a case to be made that the averages will hit bottom sometime in the next few months, even if the economy is in the middle of a recession.
Indeed, stocks showed some signs of finding a bottom late Friday, with the Dow Jones industrial average closing down just 128 points on the day, after having plummeted about 700 points earlier in the session. The Nasdaq Composite even managed a small gain on the day. Investors will be watching for a possible market bounce that could occur early this week, especially if any new measures to ease the global economic crisis emerge from the weekend's meeting in Washington of the finance ministers of the so-called G-7 industrial nations.
Scott Pollack for Barron's
The lesson of history is this: The average U.S. recession since the late 1940s has lasted 10 months, and stocks typically hit their low point about three months before the recession ends. So, if the U.S. entered a recession on July 1, as many economists now suggest, and the recession was to last until April 2009, a typical bottom for stocks would occur some time in the next few months.
Granted, much depends on the ability of the Federal Reserve and the U.S. Treasury to put rescue measures in place that will unlock today's frozen capital markets. And there are nagging concerns that the next disaster may lurk in the unregulated $60 trillion market for credit-default swaps. But the fear that sent the market down so sharply last week may have driven stocks close to their ultimate lows.
"I don't think this is the end of America as we know it," says Byron Wien, chief investment strategist at Pequot Capital Management. "I think it's conceivable that the markets will bottom before year end."
Wien cites a number of positive events in recent weeks. The Treasury now has the ability, through the $700 billion Troubled Asset Relief Program (TARP), to start buying distressed assets from banks. There is speculation the federal government will come up with yet another program to help the housing market. Oil prices have fallen below $80 a barrel from levels above $140, a slide that on its own should boost economic growth. And smart investors have started buying at what they hope are good prices. Barclays (ticker: BCS) purchased Lehman Brothers' investment-banking operations in the U.S. Warren Buffett took stakes in General Electric (GE) and Goldman Sachs (GS). Citigroup (C) and Wells Fargo (WFC) actually fought over the right to buy Wachovia (WB).
Recessions certainly have been both shorter and longer than the 10-month average. On a positive note, five recent recessions were shorter. The 1980 recession lasted a mere six months, and there were four recessions that lasted only eight months, according to data from Bespoke Investment Group.
But a mild recession wasn't what the market feared last week. Investors were worried the current economic slump will be "different" from those in the past. American consumers are carrying more debt this time around, and the banking system is in much more fragile shape.
THOUGH A TYPICAL RECESSION would end by next spring, economists are paying increasing attention to longer downturns, specifically the two recessions since 1940 that each lasted 16 months. The November 1973 to August 1975 downdraft was sparked by the Arab oil embargo, while the July 1981 to November 1982 recession was triggered by the Federal Reserve hiking interest rates dramatically to curtail runaway inflation. In each case stocks bottomed about three months before the recession ended.
The good news today is that stocks appear to have gotten out ahead of any recession, falling so sharply that they might already have priced in pretty horrible times ahead. The Dow is down almost as much in the past year as the 45% it fell in the 1973-1975 recession, and its 12-month decline far exceeds the 24% it lost in the period leading up to and during the 1981-1982 recession, according to Birinyi Associates.
Today's 40% drop also far surpasses the average bear-market slide of 30% since 1940. Markets that decline for more than a year average a loss of 42%, says Paul Desmond, President of Lowry Research Corp. The Dow has fallen by more than 40% 10 other times, with all but one such drop occurring between 1900 and 1930. It slid by more than 50% only once, between 1929 and 1932, when it shed 89%. That bear was bracketed by the Great Depression, which lasted for 44 months.
A recession is labeled a depression when economic activity shrinks by 10% or more. From August 1929 to March 1933 U.S. economic output contracted by more than 30%. That's what made it "Great."
Table: Stocks and Recessions: What History Tells UsBut back in the 'Thirties, the financial markets lacked many of today's safety nets, like deposit insurance, and the Federal Reserve didn't loosen the purse strings quickly, as the Fed lately has done. Also, the stock-market rally leading up to the Depression was much more frenzied. From 1921 to 1929, the market rose almost 500%. In the rally from 1987 to 2000, stocks jumped 574%, but did so over a much longer period. From 2002 to the market's peak in October 2007, the Dow rose 94%.
Given stocks' swoon in the past 12 months, prices look much more reasonable today. The companies in the Standard & Poor's 500 trade for an average of 11.6 times the profits that analysts expect them to earn next year. And the index trades at 17.1 times the companies' most recent earnings. That's only slightly below the market's 60-year average price/earnings multiple of 17.8, according to Birinyi Associates.
The current P/E is still high compared to the low P/Es of previous major recessions. During the '74, '80 and '82 recessions, the S&P's trailing P/E dropped to between 6.8 and 7.2. But in the '70, '90 and '01 economic downturns, the P/E ranged from 12.9 to 23.5.
The Bottom Line
Though dangers aplenty still lurk for the economy and the market, studies of stock-market performance through recessions suggest the Dow could see its low shortly.One person who fears further market declines is Wayne Nordberg, chairman of Hollow Brook Associates. "This is the end of the great credit supercycle," he says. "It takes a very long time to unwind."
Or, as Doug Cliggott, manager of the Dover Management Long-Short Sector Fund, put it with regard to the TARP, "we're fighting a forest fire with a garden hose."
But such gloomy sentiments aren't a reason to get out of the stock market. It could be quite the opposite, in fact. Consider that $1 invested in stocks from February 1966 through May 2007 would have grown to $16.58 in that period. That's a 7% annual return. By contrast, investors who were out of the market in the five best days each year during that span were left with only 11 cents.
That's a pretty good case for the buy and hold philosophy, or, if you're out of the market, for getting back in soon.
Indeed, stocks showed some signs of finding a bottom late Friday, with the Dow Jones industrial average closing down just 128 points on the day, after having plummeted about 700 points earlier in the session. The Nasdaq Composite even managed a small gain on the day. Investors will be watching for a possible market bounce that could occur early this week, especially if any new measures to ease the global economic crisis emerge from the weekend's meeting in Washington of the finance ministers of the so-called G-7 industrial nations.
Scott Pollack for Barron's
The lesson of history is this: The average U.S. recession since the late 1940s has lasted 10 months, and stocks typically hit their low point about three months before the recession ends. So, if the U.S. entered a recession on July 1, as many economists now suggest, and the recession was to last until April 2009, a typical bottom for stocks would occur some time in the next few months.
Granted, much depends on the ability of the Federal Reserve and the U.S. Treasury to put rescue measures in place that will unlock today's frozen capital markets. And there are nagging concerns that the next disaster may lurk in the unregulated $60 trillion market for credit-default swaps. But the fear that sent the market down so sharply last week may have driven stocks close to their ultimate lows.
"I don't think this is the end of America as we know it," says Byron Wien, chief investment strategist at Pequot Capital Management. "I think it's conceivable that the markets will bottom before year end."
Wien cites a number of positive events in recent weeks. The Treasury now has the ability, through the $700 billion Troubled Asset Relief Program (TARP), to start buying distressed assets from banks. There is speculation the federal government will come up with yet another program to help the housing market. Oil prices have fallen below $80 a barrel from levels above $140, a slide that on its own should boost economic growth. And smart investors have started buying at what they hope are good prices. Barclays (ticker: BCS) purchased Lehman Brothers' investment-banking operations in the U.S. Warren Buffett took stakes in General Electric (GE) and Goldman Sachs (GS). Citigroup (C) and Wells Fargo (WFC) actually fought over the right to buy Wachovia (WB).
Recessions certainly have been both shorter and longer than the 10-month average. On a positive note, five recent recessions were shorter. The 1980 recession lasted a mere six months, and there were four recessions that lasted only eight months, according to data from Bespoke Investment Group.
But a mild recession wasn't what the market feared last week. Investors were worried the current economic slump will be "different" from those in the past. American consumers are carrying more debt this time around, and the banking system is in much more fragile shape.
THOUGH A TYPICAL RECESSION would end by next spring, economists are paying increasing attention to longer downturns, specifically the two recessions since 1940 that each lasted 16 months. The November 1973 to August 1975 downdraft was sparked by the Arab oil embargo, while the July 1981 to November 1982 recession was triggered by the Federal Reserve hiking interest rates dramatically to curtail runaway inflation. In each case stocks bottomed about three months before the recession ended.
The good news today is that stocks appear to have gotten out ahead of any recession, falling so sharply that they might already have priced in pretty horrible times ahead. The Dow is down almost as much in the past year as the 45% it fell in the 1973-1975 recession, and its 12-month decline far exceeds the 24% it lost in the period leading up to and during the 1981-1982 recession, according to Birinyi Associates.
Today's 40% drop also far surpasses the average bear-market slide of 30% since 1940. Markets that decline for more than a year average a loss of 42%, says Paul Desmond, President of Lowry Research Corp. The Dow has fallen by more than 40% 10 other times, with all but one such drop occurring between 1900 and 1930. It slid by more than 50% only once, between 1929 and 1932, when it shed 89%. That bear was bracketed by the Great Depression, which lasted for 44 months.
A recession is labeled a depression when economic activity shrinks by 10% or more. From August 1929 to March 1933 U.S. economic output contracted by more than 30%. That's what made it "Great."
Table: Stocks and Recessions: What History Tells UsBut back in the 'Thirties, the financial markets lacked many of today's safety nets, like deposit insurance, and the Federal Reserve didn't loosen the purse strings quickly, as the Fed lately has done. Also, the stock-market rally leading up to the Depression was much more frenzied. From 1921 to 1929, the market rose almost 500%. In the rally from 1987 to 2000, stocks jumped 574%, but did so over a much longer period. From 2002 to the market's peak in October 2007, the Dow rose 94%.
Given stocks' swoon in the past 12 months, prices look much more reasonable today. The companies in the Standard & Poor's 500 trade for an average of 11.6 times the profits that analysts expect them to earn next year. And the index trades at 17.1 times the companies' most recent earnings. That's only slightly below the market's 60-year average price/earnings multiple of 17.8, according to Birinyi Associates.
The current P/E is still high compared to the low P/Es of previous major recessions. During the '74, '80 and '82 recessions, the S&P's trailing P/E dropped to between 6.8 and 7.2. But in the '70, '90 and '01 economic downturns, the P/E ranged from 12.9 to 23.5.
The Bottom Line
Though dangers aplenty still lurk for the economy and the market, studies of stock-market performance through recessions suggest the Dow could see its low shortly.One person who fears further market declines is Wayne Nordberg, chairman of Hollow Brook Associates. "This is the end of the great credit supercycle," he says. "It takes a very long time to unwind."
Or, as Doug Cliggott, manager of the Dover Management Long-Short Sector Fund, put it with regard to the TARP, "we're fighting a forest fire with a garden hose."
But such gloomy sentiments aren't a reason to get out of the stock market. It could be quite the opposite, in fact. Consider that $1 invested in stocks from February 1966 through May 2007 would have grown to $16.58 in that period. That's a 7% annual return. By contrast, investors who were out of the market in the five best days each year during that span were left with only 11 cents.
That's a pretty good case for the buy and hold philosophy, or, if you're out of the market, for getting back in soon.
Still Holding Back
FOR THREE YEARS, HE'S CAUTIONED INVESTORS TO AVOID RISK. Jeremy Grantham, chairman of institutional money manager GMO in Boston, was early, but eventually right.
Grantham told Barron's in February of 2006 that "housing is a classic bubble" and that "this feels like the end of a cycle." Known for his insights on global investing, Grantham, 70, co-founded GMO, which has a value framework combining quantitative and fundamental analysis. It oversees assets of about $120 billion.
For Grantham's latest views on the fallout from the financial crisis and what investment opportunities he sees, please read on.
Shawn Henry
"I can't say we are going to be in a great hurry, but our next move…will be back to emerging-market equities and small-cap international value." – Jeremy Grantham
Barron's: How much will the recent $700 billion bailout plan approved by Congress help stabilize the economy and the financial markets?
Grantham: It certainly doesn't hurt. It is an amazingly complicated situation. But I do believe we have passed the point where we have to worry about moral hazard. When Bear Stearns was in trouble, I used to worry about moral hazard.
What is your sense of how this crisis has been handled by those in charge?
It's been a haphazard response, and the next time something happens, you can't be sure what will happen. In one deal they protect the bonds, while in the next deal the bonds go. Then in the next deal they protect the foreign bonds but not the domestic bonds. My guess is that people will be nervous that they will be at the bad end of one of the tough deals, rather than one of the more gentle deals.
Everyone is shaking in their boots. The awareness of risk has come back with a terrifying surge, and it is not going to go away too quickly.
With the Fed and other central banks lowering rates last week, are you worried about inflation?
My view is, "Forget inflation, guys." This is serious, the real McCoy, and you don't have to worry about little things like inflation. Global growth will slow down, commodities will be weaker for a while, and inflation is a thing of the past. Now we are talking about getting the financial machinery to work and just keeping [gross domestic product] grinding along.
What was at the core of what got the financial system into this crisis?
It was the belief by a lot of people who counted that financial bubbles did not have to addressed. The thinking was that...you could step in and, by scattering a bit of money around, ease the downside consequences. Therefore, you could let the tech bubble run amok and wait for it to burst and step in. And you could let the housing bubble run amok and step in.
At the center of this crisis was a bubble in risk-taking. The risk premiums dropped off the cosmic scale, the lowest ever recorded. On our seven-year forecast data, we reckoned that between June of '06 and June of '07, people were actually paying for the privilege of taking risk. Our constant theme for the last three years was avoid risk, avoid risk, avoid risk.
How much further do we have to go to get through this downturn?
Great bubbles like the one in 2000 take a long time to wash through the system, and you shouldn't really expect a low much before 2010. The fair value on the [Standard & Poor's 500 index] is about 1025 [versus 910 late last week].
This was not only a monetary event, but it coincided with the first truly global bubble in all assets. You had inflated housing in almost every country in the world, except for Japan and Germany. You had overpriced stocks in every country in the world. And you had too much money and too-low interest rates. I was confident about very little, but I was confident that this would be different from anything we had seen before, and potentially more dangerous. It should have been treated with more care.
Is this crisis playing out the way you thought it would?
No. I threw in the towel three months ago, and wrote a quarterly letter saying I thought I was the bear around this joint.
But this is much worse than I thought. All the fundamentals are turning out worse than I thought they would. All the competencies of the senior people at the Fed, Treasury and [firms like Merrill Lynch and Lehman Brothers] have turned out to be much less than I had expected; that's very disappointing.
And, therefore, how could one's confidence that the senior people would get us through the storm be very high? Prior to three months ago, we were investing in emerging-market equities. Then we battened down the hatches, and I changed my view from avoid all risk except emerging markets to avoid all risk, period.
The terrible thing -- after all this pain -- is that the U.S. equity market is not even cheap. You would imagine that, given the amount of panic, that it would be. But it started from such a high level in 2000 that it still has not yet worked its way down to trend, although it is getting close. But the really bad news is that great bubbles in history always overcorrected. So although the fair value of the S&P today may be about 1025, typically bubbles overcorrect by quite a bit, possibly by 20%. That is very discouraging.
What about equities outside the U.S.?
Things are getting cheaper. We score the EAFE [the Europe, Australasia and Far East Index] as absolutely cheap, and it's offering a 7% real annual return over seven years. Emerging-market equities are a bit cheaper, and we see a 9.5% annual real return over the same period.
The problem, though, is that we have so much downside momentum, so many financial problems and so many interlocking relationships, that it is hard to imagine this crisis subsiding because stock prices are digging in their heels and approaching fair value.
What happens to hedge funds in the wake of this crisis?
A year ago, I said that half of all hedge funds would go out of business in five years, and I would certainly stand by that today. Unfortunately, like a lot of my dire projections, that may turn out to be conservative.
I also said that at least one major bank will fail. I got a lot of grief for that, and now it looks like I could have said at least a dozen major banks will fail.
As for the broad, typical opinion that we would muddle through this crisis, it just shows you what a dangerous optimistic bias the advisory business has built into it.
Do you think we will learn anything from all of this turmoil?
We will learn an enormous amount in a very short time, quite a bit in the medium term and absolutely nothing in the long term. That would be the historical precedent.
Let's talk about your asset allocations.
In a nutshell, we are as conservative as we can possibly get. One bet that has been very successful for us, touch wood, has been long high-quality, blue-chip stocks, particularly in the U.S., and short risky companies. We have been screaming against risk-taking for a long time, and in recent weeks, it has paid off enormously.
What about looking ahead in terms of asset allocation?
Going forward, you can think about slowly moving back into the cheapest pockets of global equities. So the next move that we make will be back to moderate neutral in emerging-market equities and small-cap international value. I can't say we are going to be in a great hurry, but that will be our next move. We had finished selling almost everything except emerging markets two years ago. We finished selling emerging-market equities three months ago.
But the next move will be buying, and we are encouraged that there are a few pockets that are cheap on an absolute basis. We are not encouraged that they will rally immediately. But we will be looking to buy the cheap pockets of global equities as our next move some time in the next several months.
Why emerging markets and small-cap international value?
Just value and because they have been hit the most. Emerging equities are down almost 50% since late last year, and some of small-cap international is down more than 40%. That big a drop has this wonderful effect of making these categories look cheap pretty fast. You can buy, but it doesn't mean it is their low, and I strongly suspect it is not.
The great trap is to buy too soon and, in the big move, to sell too soon. I've been saying since '98-'99 that my next major-league error will be buying too soon -- but we will not buy quite yet. But when we do, I suspect it will be too soon again.
What do you see ahead for commodities?
Commodities have a great long-term future, now that the long-term trend has shifted from falling commodity prices to rising commodity prices. Having said that, the next couple of years will be quite different. We are in a global slowdown, which I think will be worse than expected even today, and it will be longer than expected -- so this is not a healthy environment for commodities. Over a shorter horizon, I would be getting out of the way of commodities or I would be short commodities. I'm personally short oil; the firm is short copper.
What about some other trades?
I'm speaking for the asset-allocation unit at the firm. We have been substantially long the safe-haven currencies. We have been very long the yen and somewhat long the Swiss franc and short sterling, which is one of our favorite bets. We have been short the euro for three months, and slightly long the U.S. dollar. One of the paradoxes is, if the world is worse than people expect, the U.S. dollar will outperform.
Why are you shorting the euro?
It just ran too far. It went from 85 cents on the U.S. dollar to $1.60; it more or less doubled, which I don't think reflects reality. But the biggest lay-up of any idea over the last three or six months was shorting the pound.
The U.K. housing market was dreadfully overpriced. I felt nearly certain that the U.K. housing market would come back to a more normal multiple of family income, which is a very big decline of 40% if you did it in a hurry -- or you can sit back for many years and wait for income to catch up. But you should really count on that market coming down over a couple of years painfully.
Do you have any closing thoughts about how we got into this financial state?
I ask myself, "Why is it that several dozen people saw this crisis coming for years?" I described it as being like watching a train wreck in very slow motion. It seemed so inevitable and so merciless, and yet the bosses of Merrill Lynch and Citi and even [U.S. Treasury Secretary] Hank Paulson and [Fed Chairman Ben] Bernanke -- none of them seemed to see it coming.
I have a theory that people who find themselves running major-league companies are real organization-management types who focus on what they are doing this quarter or this annual budget. They are somewhat impatient, and focused on the present. Seeing these things requires more people with a historical perspective who are more thoughtful and more right-brained -- but we end up with an army of left-brained immediate doers.
So it's more or less guaranteed that every time we get an outlying, obscure event that has never happened before in history, they are always going to miss it. And the three or four-dozen-odd characters screaming about it are always going to be ignored.
If you look at the people who have been screaming about impending doom, and you added all of those several dozen people together, I don't suppose that collectively they could run a single firm without dragging it into bankruptcy in two weeks. They are just a different kind of person.
So we kept putting organization people -- people who can influence and persuade and cajole -- into top jobs that once-in-a-blue-moon take great creativity and historical insight. But they don't have those skills.
Where do you see all of this going?
I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don't. And I have no idea, really, how this will work out. I certainly wish it hadn't happened. It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect.
Grantham told Barron's in February of 2006 that "housing is a classic bubble" and that "this feels like the end of a cycle." Known for his insights on global investing, Grantham, 70, co-founded GMO, which has a value framework combining quantitative and fundamental analysis. It oversees assets of about $120 billion.
For Grantham's latest views on the fallout from the financial crisis and what investment opportunities he sees, please read on.
Shawn Henry
"I can't say we are going to be in a great hurry, but our next move…will be back to emerging-market equities and small-cap international value." – Jeremy Grantham
Barron's: How much will the recent $700 billion bailout plan approved by Congress help stabilize the economy and the financial markets?
Grantham: It certainly doesn't hurt. It is an amazingly complicated situation. But I do believe we have passed the point where we have to worry about moral hazard. When Bear Stearns was in trouble, I used to worry about moral hazard.
What is your sense of how this crisis has been handled by those in charge?
It's been a haphazard response, and the next time something happens, you can't be sure what will happen. In one deal they protect the bonds, while in the next deal the bonds go. Then in the next deal they protect the foreign bonds but not the domestic bonds. My guess is that people will be nervous that they will be at the bad end of one of the tough deals, rather than one of the more gentle deals.
Everyone is shaking in their boots. The awareness of risk has come back with a terrifying surge, and it is not going to go away too quickly.
With the Fed and other central banks lowering rates last week, are you worried about inflation?
My view is, "Forget inflation, guys." This is serious, the real McCoy, and you don't have to worry about little things like inflation. Global growth will slow down, commodities will be weaker for a while, and inflation is a thing of the past. Now we are talking about getting the financial machinery to work and just keeping [gross domestic product] grinding along.
What was at the core of what got the financial system into this crisis?
It was the belief by a lot of people who counted that financial bubbles did not have to addressed. The thinking was that...you could step in and, by scattering a bit of money around, ease the downside consequences. Therefore, you could let the tech bubble run amok and wait for it to burst and step in. And you could let the housing bubble run amok and step in.
At the center of this crisis was a bubble in risk-taking. The risk premiums dropped off the cosmic scale, the lowest ever recorded. On our seven-year forecast data, we reckoned that between June of '06 and June of '07, people were actually paying for the privilege of taking risk. Our constant theme for the last three years was avoid risk, avoid risk, avoid risk.
How much further do we have to go to get through this downturn?
Great bubbles like the one in 2000 take a long time to wash through the system, and you shouldn't really expect a low much before 2010. The fair value on the [Standard & Poor's 500 index] is about 1025 [versus 910 late last week].
This was not only a monetary event, but it coincided with the first truly global bubble in all assets. You had inflated housing in almost every country in the world, except for Japan and Germany. You had overpriced stocks in every country in the world. And you had too much money and too-low interest rates. I was confident about very little, but I was confident that this would be different from anything we had seen before, and potentially more dangerous. It should have been treated with more care.
Is this crisis playing out the way you thought it would?
No. I threw in the towel three months ago, and wrote a quarterly letter saying I thought I was the bear around this joint.
But this is much worse than I thought. All the fundamentals are turning out worse than I thought they would. All the competencies of the senior people at the Fed, Treasury and [firms like Merrill Lynch and Lehman Brothers] have turned out to be much less than I had expected; that's very disappointing.
And, therefore, how could one's confidence that the senior people would get us through the storm be very high? Prior to three months ago, we were investing in emerging-market equities. Then we battened down the hatches, and I changed my view from avoid all risk except emerging markets to avoid all risk, period.
The terrible thing -- after all this pain -- is that the U.S. equity market is not even cheap. You would imagine that, given the amount of panic, that it would be. But it started from such a high level in 2000 that it still has not yet worked its way down to trend, although it is getting close. But the really bad news is that great bubbles in history always overcorrected. So although the fair value of the S&P today may be about 1025, typically bubbles overcorrect by quite a bit, possibly by 20%. That is very discouraging.
What about equities outside the U.S.?
Things are getting cheaper. We score the EAFE [the Europe, Australasia and Far East Index] as absolutely cheap, and it's offering a 7% real annual return over seven years. Emerging-market equities are a bit cheaper, and we see a 9.5% annual real return over the same period.
The problem, though, is that we have so much downside momentum, so many financial problems and so many interlocking relationships, that it is hard to imagine this crisis subsiding because stock prices are digging in their heels and approaching fair value.
What happens to hedge funds in the wake of this crisis?
A year ago, I said that half of all hedge funds would go out of business in five years, and I would certainly stand by that today. Unfortunately, like a lot of my dire projections, that may turn out to be conservative.
I also said that at least one major bank will fail. I got a lot of grief for that, and now it looks like I could have said at least a dozen major banks will fail.
As for the broad, typical opinion that we would muddle through this crisis, it just shows you what a dangerous optimistic bias the advisory business has built into it.
Do you think we will learn anything from all of this turmoil?
We will learn an enormous amount in a very short time, quite a bit in the medium term and absolutely nothing in the long term. That would be the historical precedent.
Let's talk about your asset allocations.
In a nutshell, we are as conservative as we can possibly get. One bet that has been very successful for us, touch wood, has been long high-quality, blue-chip stocks, particularly in the U.S., and short risky companies. We have been screaming against risk-taking for a long time, and in recent weeks, it has paid off enormously.
What about looking ahead in terms of asset allocation?
Going forward, you can think about slowly moving back into the cheapest pockets of global equities. So the next move that we make will be back to moderate neutral in emerging-market equities and small-cap international value. I can't say we are going to be in a great hurry, but that will be our next move. We had finished selling almost everything except emerging markets two years ago. We finished selling emerging-market equities three months ago.
But the next move will be buying, and we are encouraged that there are a few pockets that are cheap on an absolute basis. We are not encouraged that they will rally immediately. But we will be looking to buy the cheap pockets of global equities as our next move some time in the next several months.
Why emerging markets and small-cap international value?
Just value and because they have been hit the most. Emerging equities are down almost 50% since late last year, and some of small-cap international is down more than 40%. That big a drop has this wonderful effect of making these categories look cheap pretty fast. You can buy, but it doesn't mean it is their low, and I strongly suspect it is not.
The great trap is to buy too soon and, in the big move, to sell too soon. I've been saying since '98-'99 that my next major-league error will be buying too soon -- but we will not buy quite yet. But when we do, I suspect it will be too soon again.
What do you see ahead for commodities?
Commodities have a great long-term future, now that the long-term trend has shifted from falling commodity prices to rising commodity prices. Having said that, the next couple of years will be quite different. We are in a global slowdown, which I think will be worse than expected even today, and it will be longer than expected -- so this is not a healthy environment for commodities. Over a shorter horizon, I would be getting out of the way of commodities or I would be short commodities. I'm personally short oil; the firm is short copper.
What about some other trades?
I'm speaking for the asset-allocation unit at the firm. We have been substantially long the safe-haven currencies. We have been very long the yen and somewhat long the Swiss franc and short sterling, which is one of our favorite bets. We have been short the euro for three months, and slightly long the U.S. dollar. One of the paradoxes is, if the world is worse than people expect, the U.S. dollar will outperform.
Why are you shorting the euro?
It just ran too far. It went from 85 cents on the U.S. dollar to $1.60; it more or less doubled, which I don't think reflects reality. But the biggest lay-up of any idea over the last three or six months was shorting the pound.
The U.K. housing market was dreadfully overpriced. I felt nearly certain that the U.K. housing market would come back to a more normal multiple of family income, which is a very big decline of 40% if you did it in a hurry -- or you can sit back for many years and wait for income to catch up. But you should really count on that market coming down over a couple of years painfully.
Do you have any closing thoughts about how we got into this financial state?
I ask myself, "Why is it that several dozen people saw this crisis coming for years?" I described it as being like watching a train wreck in very slow motion. It seemed so inevitable and so merciless, and yet the bosses of Merrill Lynch and Citi and even [U.S. Treasury Secretary] Hank Paulson and [Fed Chairman Ben] Bernanke -- none of them seemed to see it coming.
I have a theory that people who find themselves running major-league companies are real organization-management types who focus on what they are doing this quarter or this annual budget. They are somewhat impatient, and focused on the present. Seeing these things requires more people with a historical perspective who are more thoughtful and more right-brained -- but we end up with an army of left-brained immediate doers.
So it's more or less guaranteed that every time we get an outlying, obscure event that has never happened before in history, they are always going to miss it. And the three or four-dozen-odd characters screaming about it are always going to be ignored.
If you look at the people who have been screaming about impending doom, and you added all of those several dozen people together, I don't suppose that collectively they could run a single firm without dragging it into bankruptcy in two weeks. They are just a different kind of person.
So we kept putting organization people -- people who can influence and persuade and cajole -- into top jobs that once-in-a-blue-moon take great creativity and historical insight. But they don't have those skills.
Where do you see all of this going?
I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don't. And I have no idea, really, how this will work out. I certainly wish it hadn't happened. It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect.
A little perspective, please
How did this crisis happen? Could it get worse? When will the pain end ? If you were looking for answers to those questions - and you should be - you'd seek out someone with knowledge of the past and a record for being right about the future.
Allow us, then, to introduce you to three people rich in both. Diane Swonk, the chief economist of Chicago's Mesirow Financial, has been named one of the country's top forecasters and is an adviser to the Federal Reserve Board.
Jeremy Grantham, co-founder of the investment firm GMO, was one of the first investors to foresee that the financial system was headed for a breakdown.
And market historian John Steele Gordon, whose grandfathers held seats on the New York Stock Exchange, has chronicled America's long history of booms and busts in An Empire of Wealth.
Reporter Joe Light and senior writer Janice Revell spoke with them in mid-September.
In retrospect, there were plenty of signs pointing to the serious and growing problems in the financial system before everything seemed to fall apart at once. Why didn't anyone, on Wall Street or in Washington, take action sooner?
Jeremy Grantham: We got so good at denial. The Fed was in denial, the Treasury was in denial, the bosses of Merrill Lynch and Lehman were in denial. And yet this crisis was the most widely heralded "surprise" in the history of finance - there were plenty of people warning that it was going to happen long before it did.
You were one of them. What did you see that bothered you?
Grantham: All you had to do was open a history book and see what happens when you have a bubble. In this case, there was a bubble in housing and there was a magnificent bubble in risk taking. People were just shoveling their money into risk on the pathetic idea that risk is always rewarded.
That is completely misguided. You don't get rewarded for taking risk; you get rewarded for buying cheap assets. And if the assets you bought got pushed up in price simply because they were risky, then you are not going to be rewarded for taking a risk; you are going to be punished for it.
You can lay the evidence in front of everybody, but they will yawn and ignore it. It's that denial that's impressive. It's what happens in bubbles.
How did individual homeowners contribute to the current meltdown?
Diane Swonk: The housing bubble is certainly the root of the problem in the financial markets. If you were a home buyer, you didn't have to have any skin in the game, you didn't have to put any equity down to get a mortgage.
Another problem is the ease with which people can walk away from their homes in this country. A home buyer can say to a bank, "Here are the keys; the house is your problem now. But I'm going to keep my car, my 401(k) and everything else."
No other major industrialized country in the world allows that. And it encouraged homeowners here to take more risk, to put zero money down.
How much at risk were the financial institutions involved? That is, was this degree of intervention really necessary?
Grantham: Leverage is the ultimate demonstration of risk, and we never had system-wide leverage like this before. Ever. We had several firms that were leveraged 30 to 1. [For every $30 of assets on their books, they put up $1 of equity and borrowed the other $29.] At leverage of 30 to 1, you have to lose only about 3% on your $30 worth of assets and your dollar of equity gets wiped out. You're bankrupt.
Why would those financial firms take on such extreme risk?
Grantham: They believed their risk models, which said they had a diversified portfolio, so their investments couldn't all go down together. And the potential rewards were out of whack with the risk.
Say you're in the hedge fund division of some investment bank and you have a billion dollars to invest. You hit the ball out of the park, make 120% on that billion and probably walk away with a $45 million bonus. If you lose the billion dollars, you're fired. Hey, that's not bad! If I thought the odds of success were fifty-fifty, I'd be a fool not to try.
How bad is our current situation compared with previous financial crises?
John Steele Gordon: It feels bad but not like a panic. In a classic panic, as in 1987 or 1929, everyone was selling and prices went through the floor. The market lost 22% on Oct. 19, 1987, compared with 4% on the day Lehman filed for bankruptcy. We were getting close to a breakdown in the whole financial system, but now that decisive government actions are being taken, we're stepping back from the brink.
By comparison, after the 1929 stock market crash, the government didn't do much of anything - and what they did do just made the situation worse. For instance, the Fed kept interest rates high and the government implemented the largest tariff in American history, which was effectively a big tax increase in a declining economy. These things converted a perfectly ordinary recession and market crash into the greatest economic calamity in American history.
In 1987, on the other hand, it was the Federal Reserve that ended the panic. The Fed basically called up Wall Street and said, "Listen, you guys need liquidity. Bring your wheelbarrows and we'll fill them up." We've seen a similar use of the Fed in the current crisis.
How have other countries responded to the deteriorating situation here?
Swonk: This is one aspect of the crisis that most people aren't talking about. The financial liquidity that has been infused into the market to provide stability has come not only from the Federal Reserve but from international sources as well. The European Central Bank and the Bank of Japan have been very involved.
The reality is setting in that globalization has made us all intrinsically linked, and coordination of policy across borders is critical. That is not the place America was in during the Great Depression. Then the rest of the world was still hurting financially from World War I and there was nowhere to go outside the U.S. to raise money. Today there are a lot of places to go.
Is a massive government rescue program really necessary?
Swonk: The piecemeal approach to creating some sort of backstop to the financial system - Bear Stearns, AIG and so on - appeared to add more panic than confidence to the markets. We needed a more holistic approach to stop the bloodletting, especially once it started to affect short-term credit.
What about the cost to taxpayers?
Gordon: People thought the cost associated with the S&L crisis would be two or three times larger than the $150 billion it turned out to be. At the time the S&L's problem assets - real estate - would have overwhelmed the market if sold at once. The government later sold them for much more than people originally thought they could. That may also be the case today.
We've now seen huge banks acquire other huge banks. Are these massive financial institutions dangerous?
Gordon: It's good because it makes the banks more stable. A lot of the banking problems we had earlier in our history occurred because the banks were so small. In 1920 we had 30,000 banks in this country; each small town had its own bank. If the economy of that small town went into the toilet - a factory closed or there was a long drought - the bank went broke because there was such a small base supporting it.
The more widespread a bank is, the more stable it is. If something goes wrong in one area, there are other places where things are going well to offset that.
What can the past tell us about where the stock market is going next?
Grantham: Historically, when a market bubble has popped, it has almost always overcorrected. But after the tech bubble burst in 2000, the stock market didn't hit the lows it should have.
Before it could, the housing bubble and tax cuts that followed 9/11 kicked off the biggest sucker rally in history, from 2002 to 2006. So I think the market isn't cheap yet. There is more pain coming. I don't think we'll hit the low until 2010.
Swonk: But even though the market is turbulent and scary today, we're still looking at a pretty favorable environment over the longer term for stocks. Productivity growth is accelerating - we all know this, of course, because we're working harder for less money. Rising productivity leads to rising corporate profits. That, historically, has been highly correlated with a bull market.
What's your advice to investors now?
Grantham: Understand that the market may recover for a while and then go to a new low. One of the lessons I have learned over the years is that things can get a whole lot more extreme, both up and down, than you ever dreamed of. So we may drop another 30% before we hit bottom.
Keep telling yourself every night that you're a long-term investor and don't look at daily stock prices. And it's not too late to shift some of your money to high-quality blue chips. Emerging markets are probably no longer too expensive either. If you had 80% of your stockholdings in blue chips and 20% in emerging markets, you'd have a pretty reasonable portfolio to ride out the bad times.
Gordon: Psychology is central in these kinds of markets. Don't panic, that's the No. 1 rule, and think long term.
What's ahead for the economy now?
Swonk: We can't really avoid the economy getting worse before it gets better. We don't have the tax rebates helping us out anymore. Labor markets have deteriorated further, and people who are working are in many cases earning less. So I don't think we'll recover before 2010. It won't be until then that housing prices stabilize, and that's the key issue.
I'm confident that they will by 2010 because we are still creating a million new households a year and those people have to live somewhere. We've got some fundamentals working for us, but it will take a while to get there.
What needs to change to prevent another crisis from happening?
Gordon: We need a thorough housecleaning of the financial regulation system. Right now it isn't even really a system. It just sort of grew over the years and doesn't make a whole lot of sense.
You have the Federal Reserve, the Comptroller of the Currency, the FDIC, the SEC, state banking authorities and state insurance authorities - and all of them working at cross-purposes. It doesn't make any sense at all anymore.
Is there a silver lining to all of this ?
Grantham: People lost the knack of thinking that cheaper assets are better. We're going to return to that way of thinking, and that's incredibly good news.
Allow us, then, to introduce you to three people rich in both. Diane Swonk, the chief economist of Chicago's Mesirow Financial, has been named one of the country's top forecasters and is an adviser to the Federal Reserve Board.
Jeremy Grantham, co-founder of the investment firm GMO, was one of the first investors to foresee that the financial system was headed for a breakdown.
And market historian John Steele Gordon, whose grandfathers held seats on the New York Stock Exchange, has chronicled America's long history of booms and busts in An Empire of Wealth.
Reporter Joe Light and senior writer Janice Revell spoke with them in mid-September.
In retrospect, there were plenty of signs pointing to the serious and growing problems in the financial system before everything seemed to fall apart at once. Why didn't anyone, on Wall Street or in Washington, take action sooner?
Jeremy Grantham: We got so good at denial. The Fed was in denial, the Treasury was in denial, the bosses of Merrill Lynch and Lehman were in denial. And yet this crisis was the most widely heralded "surprise" in the history of finance - there were plenty of people warning that it was going to happen long before it did.
You were one of them. What did you see that bothered you?
Grantham: All you had to do was open a history book and see what happens when you have a bubble. In this case, there was a bubble in housing and there was a magnificent bubble in risk taking. People were just shoveling their money into risk on the pathetic idea that risk is always rewarded.
That is completely misguided. You don't get rewarded for taking risk; you get rewarded for buying cheap assets. And if the assets you bought got pushed up in price simply because they were risky, then you are not going to be rewarded for taking a risk; you are going to be punished for it.
You can lay the evidence in front of everybody, but they will yawn and ignore it. It's that denial that's impressive. It's what happens in bubbles.
How did individual homeowners contribute to the current meltdown?
Diane Swonk: The housing bubble is certainly the root of the problem in the financial markets. If you were a home buyer, you didn't have to have any skin in the game, you didn't have to put any equity down to get a mortgage.
Another problem is the ease with which people can walk away from their homes in this country. A home buyer can say to a bank, "Here are the keys; the house is your problem now. But I'm going to keep my car, my 401(k) and everything else."
No other major industrialized country in the world allows that. And it encouraged homeowners here to take more risk, to put zero money down.
How much at risk were the financial institutions involved? That is, was this degree of intervention really necessary?
Grantham: Leverage is the ultimate demonstration of risk, and we never had system-wide leverage like this before. Ever. We had several firms that were leveraged 30 to 1. [For every $30 of assets on their books, they put up $1 of equity and borrowed the other $29.] At leverage of 30 to 1, you have to lose only about 3% on your $30 worth of assets and your dollar of equity gets wiped out. You're bankrupt.
Why would those financial firms take on such extreme risk?
Grantham: They believed their risk models, which said they had a diversified portfolio, so their investments couldn't all go down together. And the potential rewards were out of whack with the risk.
Say you're in the hedge fund division of some investment bank and you have a billion dollars to invest. You hit the ball out of the park, make 120% on that billion and probably walk away with a $45 million bonus. If you lose the billion dollars, you're fired. Hey, that's not bad! If I thought the odds of success were fifty-fifty, I'd be a fool not to try.
How bad is our current situation compared with previous financial crises?
John Steele Gordon: It feels bad but not like a panic. In a classic panic, as in 1987 or 1929, everyone was selling and prices went through the floor. The market lost 22% on Oct. 19, 1987, compared with 4% on the day Lehman filed for bankruptcy. We were getting close to a breakdown in the whole financial system, but now that decisive government actions are being taken, we're stepping back from the brink.
By comparison, after the 1929 stock market crash, the government didn't do much of anything - and what they did do just made the situation worse. For instance, the Fed kept interest rates high and the government implemented the largest tariff in American history, which was effectively a big tax increase in a declining economy. These things converted a perfectly ordinary recession and market crash into the greatest economic calamity in American history.
In 1987, on the other hand, it was the Federal Reserve that ended the panic. The Fed basically called up Wall Street and said, "Listen, you guys need liquidity. Bring your wheelbarrows and we'll fill them up." We've seen a similar use of the Fed in the current crisis.
How have other countries responded to the deteriorating situation here?
Swonk: This is one aspect of the crisis that most people aren't talking about. The financial liquidity that has been infused into the market to provide stability has come not only from the Federal Reserve but from international sources as well. The European Central Bank and the Bank of Japan have been very involved.
The reality is setting in that globalization has made us all intrinsically linked, and coordination of policy across borders is critical. That is not the place America was in during the Great Depression. Then the rest of the world was still hurting financially from World War I and there was nowhere to go outside the U.S. to raise money. Today there are a lot of places to go.
Is a massive government rescue program really necessary?
Swonk: The piecemeal approach to creating some sort of backstop to the financial system - Bear Stearns, AIG and so on - appeared to add more panic than confidence to the markets. We needed a more holistic approach to stop the bloodletting, especially once it started to affect short-term credit.
What about the cost to taxpayers?
Gordon: People thought the cost associated with the S&L crisis would be two or three times larger than the $150 billion it turned out to be. At the time the S&L's problem assets - real estate - would have overwhelmed the market if sold at once. The government later sold them for much more than people originally thought they could. That may also be the case today.
We've now seen huge banks acquire other huge banks. Are these massive financial institutions dangerous?
Gordon: It's good because it makes the banks more stable. A lot of the banking problems we had earlier in our history occurred because the banks were so small. In 1920 we had 30,000 banks in this country; each small town had its own bank. If the economy of that small town went into the toilet - a factory closed or there was a long drought - the bank went broke because there was such a small base supporting it.
The more widespread a bank is, the more stable it is. If something goes wrong in one area, there are other places where things are going well to offset that.
What can the past tell us about where the stock market is going next?
Grantham: Historically, when a market bubble has popped, it has almost always overcorrected. But after the tech bubble burst in 2000, the stock market didn't hit the lows it should have.
Before it could, the housing bubble and tax cuts that followed 9/11 kicked off the biggest sucker rally in history, from 2002 to 2006. So I think the market isn't cheap yet. There is more pain coming. I don't think we'll hit the low until 2010.
Swonk: But even though the market is turbulent and scary today, we're still looking at a pretty favorable environment over the longer term for stocks. Productivity growth is accelerating - we all know this, of course, because we're working harder for less money. Rising productivity leads to rising corporate profits. That, historically, has been highly correlated with a bull market.
What's your advice to investors now?
Grantham: Understand that the market may recover for a while and then go to a new low. One of the lessons I have learned over the years is that things can get a whole lot more extreme, both up and down, than you ever dreamed of. So we may drop another 30% before we hit bottom.
Keep telling yourself every night that you're a long-term investor and don't look at daily stock prices. And it's not too late to shift some of your money to high-quality blue chips. Emerging markets are probably no longer too expensive either. If you had 80% of your stockholdings in blue chips and 20% in emerging markets, you'd have a pretty reasonable portfolio to ride out the bad times.
Gordon: Psychology is central in these kinds of markets. Don't panic, that's the No. 1 rule, and think long term.
What's ahead for the economy now?
Swonk: We can't really avoid the economy getting worse before it gets better. We don't have the tax rebates helping us out anymore. Labor markets have deteriorated further, and people who are working are in many cases earning less. So I don't think we'll recover before 2010. It won't be until then that housing prices stabilize, and that's the key issue.
I'm confident that they will by 2010 because we are still creating a million new households a year and those people have to live somewhere. We've got some fundamentals working for us, but it will take a while to get there.
What needs to change to prevent another crisis from happening?
Gordon: We need a thorough housecleaning of the financial regulation system. Right now it isn't even really a system. It just sort of grew over the years and doesn't make a whole lot of sense.
You have the Federal Reserve, the Comptroller of the Currency, the FDIC, the SEC, state banking authorities and state insurance authorities - and all of them working at cross-purposes. It doesn't make any sense at all anymore.
Is there a silver lining to all of this ?
Grantham: People lost the knack of thinking that cheaper assets are better. We're going to return to that way of thinking, and that's incredibly good news.
Thursday, October 9, 2008
Marc Faber Gives Investors Some Hope
Investor Marc Faber said a series of coordinated interest-rate cuts by central banks including the Federal Reserve to ease the economic effects of the global financial crisis won’t halt a worldwide slide in equities…
“The slashing of interest rates will not help very much,” Faber, who manages $300 million, said in an interview in Manila. “They may cushion somewhat the decline but make matters worse.”
The Swiss-born investor added:
Had central banks around the world kept interest rates that encourage saving we wouldn’t have these problems today.
However, Dr. Faber believes there still remains a glimmer of hope for investors in equities. From the CNBC website yesterday:
The stock market is as oversold as it has been since the crash of 1987 and the broader market could start to rebound until early next year, Marc Faber, editor and publisher of the Gloom Boom and Doom Report, said Tuesday.
The market is possibly in “the most oversold condition” since perhaps Oct. 19, 1987, Faber told CNBC’s “Squawk Box.”
“Usually there is some seasonal strength between October and March” so it is possible the S&P 500 index will create a low between now and the end of the month, he said.
He talked about some areas investors should be looking at:
Longer-term investors will have to position themselves in emerging country stock markets to play the global recovery, Faber advised.
Faber, who recommended buying gold at the start of its six-year rally, also pointed out:
For now, gold is still attractive, with central banks readying more rate cuts and printing money, he said.
“The slashing of interest rates will not help very much,” Faber, who manages $300 million, said in an interview in Manila. “They may cushion somewhat the decline but make matters worse.”
The Swiss-born investor added:
Had central banks around the world kept interest rates that encourage saving we wouldn’t have these problems today.
However, Dr. Faber believes there still remains a glimmer of hope for investors in equities. From the CNBC website yesterday:
The stock market is as oversold as it has been since the crash of 1987 and the broader market could start to rebound until early next year, Marc Faber, editor and publisher of the Gloom Boom and Doom Report, said Tuesday.
The market is possibly in “the most oversold condition” since perhaps Oct. 19, 1987, Faber told CNBC’s “Squawk Box.”
“Usually there is some seasonal strength between October and March” so it is possible the S&P 500 index will create a low between now and the end of the month, he said.
He talked about some areas investors should be looking at:
Longer-term investors will have to position themselves in emerging country stock markets to play the global recovery, Faber advised.
Faber, who recommended buying gold at the start of its six-year rally, also pointed out:
For now, gold is still attractive, with central banks readying more rate cuts and printing money, he said.
Wednesday, October 8, 2008
Rolling 7 Day DJIA Returns <-15%
9 of the 39 cases since 1928 were not during the Depression:
Date 7D
09/21/01 -0.163
09/20/01 -0.165
10/27/87 -0.178
10/26/87 -0.238
10/23/87 -0.191
10/22/87 -0.222
10/21/87 -0.179
10/20/87 -0.258
10/19/87 -0.309
05/22/40 -0.166
05/21/40 -0.212
05/20/40 -0.174
05/17/40 -0.161
03/31/38 -0.155
03/30/38 -0.161
10/19/33 -0.154
07/21/33 -0.152
10/13/32 -0.161
10/10/32 -0.183
09/19/32 -0.160
09/16/32 -0.161
06/01/32 -0.157
05/31/32 -0.158
04/11/32 -0.153
04/08/32 -0.185
12/16/31 -0.151
10/05/31 -0.198
10/02/31 -0.165
06/24/30 -0.152
11/14/29 -0.157
11/13/29 -0.274
11/12/29 -0.189
11/07/29 -0.209
11/06/29 -0.225
11/04/29 -0.157
10/31/29 -0.162
10/30/29 -0.195
10/29/29 -0.310
10/28/29 -0.238
Date 7D
09/21/01 -0.163
09/20/01 -0.165
10/27/87 -0.178
10/26/87 -0.238
10/23/87 -0.191
10/22/87 -0.222
10/21/87 -0.179
10/20/87 -0.258
10/19/87 -0.309
05/22/40 -0.166
05/21/40 -0.212
05/20/40 -0.174
05/17/40 -0.161
03/31/38 -0.155
03/30/38 -0.161
10/19/33 -0.154
07/21/33 -0.152
10/13/32 -0.161
10/10/32 -0.183
09/19/32 -0.160
09/16/32 -0.161
06/01/32 -0.157
05/31/32 -0.158
04/11/32 -0.153
04/08/32 -0.185
12/16/31 -0.151
10/05/31 -0.198
10/02/31 -0.165
06/24/30 -0.152
11/14/29 -0.157
11/13/29 -0.274
11/12/29 -0.189
11/07/29 -0.209
11/06/29 -0.225
11/04/29 -0.157
10/31/29 -0.162
10/30/29 -0.195
10/29/29 -0.310
10/28/29 -0.238
Monday, October 6, 2008
Time To Go Long, At Least For A Short Time?
The violent sell-off in stock markets Monday morning, along with the stream of bad economic news of last week, is bound to provoke substantial cuts in short-term interest rates by the Federal Reserve and other central banks. Stock markets should thus be near a good rebound, especially given near-term oversold conditions.
If you went into those double-short ETFs last week, take the 10% to 25% gains so far and shift into the double-long ETFs. There is a list at Stock-Encyclopedia.com. I myself bought the Horizons BetaPro S&P/TSX 60 Bull Plus ETF (HXU) and the ProShares Ultra S&P500 ETF (SSO) – or should the symbol be SOS now?). It could be early and the double-long ETFs could come down fast, but they can come back fast too.
If and when the rally comes, it may be short-lived as attention shifts back to the worsening economic indicators parading through the headlines. So one could don their trader’s hat … or consider buying and holding since it’s hard to imagine stocks staying below this level over the next year to three years. Moreover, the Fed and politicians will likely have a number of other counterpunches lined up after the first rate cut.
If you went into those double-short ETFs last week, take the 10% to 25% gains so far and shift into the double-long ETFs. There is a list at Stock-Encyclopedia.com. I myself bought the Horizons BetaPro S&P/TSX 60 Bull Plus ETF (HXU) and the ProShares Ultra S&P500 ETF (SSO) – or should the symbol be SOS now?). It could be early and the double-long ETFs could come down fast, but they can come back fast too.
If and when the rally comes, it may be short-lived as attention shifts back to the worsening economic indicators parading through the headlines. So one could don their trader’s hat … or consider buying and holding since it’s hard to imagine stocks staying below this level over the next year to three years. Moreover, the Fed and politicians will likely have a number of other counterpunches lined up after the first rate cut.
Wednesday, October 1, 2008
Reflection on the Crash
1. It was symmetric with the previous week where it opened limit up on the news. They had reached a compromise, and then it went limit down, indeed 100 down when they didn't reach an agreement. Amazing that the time horizon is so short. As soon as they voted the agreement down, it was clear that they'd come up with an agreement shortly. The stock market took care of that. "It's amazing how a 900 point drop in Dow can get their attention" with all the lobbyists involved, and the power increases, but yet the leverage of traders is so great that they automatically get exited from their positions on bad news even if it's going to be reversed the next day at the open.
2. This crash and the Oct 19, 1987 both were symmetric in that the Secretary of the Treasury caused it. In the first one, Jim Baker said, "The Europeans have to strengthen the currencies." In this case, there was revulsion against a political plan to feather the nest of both parties. The bonds in both cases had their biggest up moves in history, but in 1987 they stayed up for the next week, and in this case they reversed the next day. Commodities had one of their worst days in history showing that all markets are interrelated and when wealth goes down, all spending is reduced.
3. This crash brought all markets to many year lows, and was the final revulsion, the final throwing the frog into hot water that cleared the decks as the move the next day, one of biggest in history, showed. The discount rate is always ready to be lowered when the market goes down by more than 4% in a day as it did on Jan 21, and in Aug 2007.
4. The European markets were down a few percent more than the US at the open, as were Japan and Israel, foretelling what was going to happen.
2. This crash and the Oct 19, 1987 both were symmetric in that the Secretary of the Treasury caused it. In the first one, Jim Baker said, "The Europeans have to strengthen the currencies." In this case, there was revulsion against a political plan to feather the nest of both parties. The bonds in both cases had their biggest up moves in history, but in 1987 they stayed up for the next week, and in this case they reversed the next day. Commodities had one of their worst days in history showing that all markets are interrelated and when wealth goes down, all spending is reduced.
3. This crash brought all markets to many year lows, and was the final revulsion, the final throwing the frog into hot water that cleared the decks as the move the next day, one of biggest in history, showed. The discount rate is always ready to be lowered when the market goes down by more than 4% in a day as it did on Jan 21, and in Aug 2007.
4. The European markets were down a few percent more than the US at the open, as were Japan and Israel, foretelling what was going to happen.
Tuesday, September 30, 2008
SP500 to 1000 as bottom
After experiencing the worst one day loss on Monday since the market crash on October 19, 1987, markets rallied hard, with the Dow closing up nearly 500 points. There were several reasons for the gain.
1. The market was oversold
When only one stock in the S&P 500 goes up and the downside volume to upside volume is 26.5:1, as it was on Monday, a snapback rally is no surprise.
2. Belief that the government will still bail out the market.
This was the main reason why the market was up. Frankly, I am in disbelief of the market's credulity on this one. Yesterday, I wrote that Washington has no credibility on Wall Street, given that the House sandbagged the market, voting down TARP. I was wrong. Apparently Washington has a great deal of credibility on Wall Street, despite getting blindsided yesterday. I want Washington to do something, but there is a part of me that would like to see this fail just to wring the gullibility out of Wall Street. If the legislators fail and a bill does not pass and the market falls another 1000 points, then Wall Street will have no one to blame but themselves.
3. Suspension of mark-to-market accounting
Investors were under the impression that mark-to-market accounting, FASB 157, would be suspended. The SEC released a statement clarifying the interpretation of mark-to-market but did not say it would be suspended. The idea is that banks would not have to mark down their assets to recent market transactions if FASB 157 were suspended. The proponents argue that current market transactions represent distressed sales and not the true value of the underlying assets, but companies have to mark their assets to those unrealistic levels. Suspending the accounting rule will stop the death spiral of financial companies.
I think this is a canard. It would be yet another gimmick akin to suspending short selling. Financial companies are not collapsing because of mark-to-market accounting. They are collapsing because they did really dumb things and took on too much debt. Investors aren't stupid. Increasing opacity in the financial statements does not help investors understand the risks of the company in which they are investing. Compare the likes of AIG, Freddie Mac, Fannie Mae, Bear Stearns, IndyMac, and Lehman with the likes of US Bancorp and Wells Fargo. The former collapsed because they made bad business decisions whereas the latter are near 52 week highs because they didn't over-lever their balance sheets and make stupid investments.
Also, there are pools of capital out there waiting to invest in distressed assets. However, few transactions have occurred. Many of these pools of capital have long-term lock-ups of three or more years. They can handle the volatility of mark-to-market accounting if distressed sales are below intrinsic value because their investors cannot call their capital. Yet, few transactions are being done. Why? Could it be that the funds do not believe that the assets for sale are ridiculously cheap?
4. Stocks did not collapse so traders bought.
This is perhaps the most discouraging reason for the market's gain today. The willingness to buy in front of news after a hard down day does not seem to me to be behaviour one sees at the bottom. I would have preferred that investors puked out stocks rather than believe Washington will come to their rescue and buy the dips hopefully.
5. The possibility of an increase in FDIC insurance.
Today, the government of Ireland guaranteed bank deposits. There was chatter that the FDIC may increase insurance from $100,000 to $250,000. Some were saying that deposit insurance may become unlimited. Never mind that the FDIC might not be capitalized enough to handle all the bank failures to come, the government stepping up to guarantee all deposits was probably the single most bullish news today as it would make bank runs less likely. It could tank the dollar, but there are so many factors that could also tank the dollar, what's another one, eh?
6. ECB rate cut
Rumours had it that the ECB would cut rates soon. This very well may be true. The bank will start cutting rates shortly. Given the incredible stresses on the financial system, the rate cut may come sooner rather than later.
7. Money market pressures ease.
Slightly. The TED spread was over 3.5% today before easing to 3.15%, still very high but not as high as earlier in the day. The 3-month Treasury bill oscillated between 0.5% and 1% while swap spreads, though still high, were lower than yesterday. The Fed has pushed in an enormous amount of liquidity over the past few weeks to meet the insatiable demand for dollars. You could see the tremendous volatility in the Fed funds market, with rates as high as 7% this morning and falling to 0.125% this afternoon. Such volatility has been the norm as of late. This is why I'm not sure rate cuts by the Fed would be helpful in the near term.
8. Better than expected economic news
Forgotten by many was that the Chicago PMI and the Conference Board's consumer confidence index came in better than expected this morning.
9. Month and quarter end.
Month and quarter ends often bring unusual activity.
Volume was lighter than yesterday. Upside volume was 9.1:1 to downside volume, good but was dwarfed by Monday's 26.5:1 volume to the downside. It appears that the rally merely brings the indices back to within range where one would expect the market to start selling off again.
I keep hearing investors claim the market is cheap. I do not think so. I use $75 as my normalized earnings estimate, assuming a 7.5% margin, which is well above the long-term average of 6%. At $75, the market is trading at 15.5x earnings. That is not cheap. It is not expensive but it is not where bear markets have historically bottomed.
The average bear market since World War II has generated losses of 28%. To the lows yesterday, the market was down 30%, top to bottom. I contend that the worst credit crisis since the Depression will not lead to an average bear market in stocks.
The two worst bear markets during this time were 1973-74 and 2000-02, both of which saw declines of 50%. I do not think the decline in this bear market will be 50%, but instead will be somewhere between 30% and 50%. I'll pick 40% because it is a nice round number, which would take us to around 1000 on the S&P 500.
I do not know if the near-term bottom is in but I highly doubt the ultimate bottom is in. Thus, rallies remain to be sold.
1. The market was oversold
When only one stock in the S&P 500 goes up and the downside volume to upside volume is 26.5:1, as it was on Monday, a snapback rally is no surprise.
2. Belief that the government will still bail out the market.
This was the main reason why the market was up. Frankly, I am in disbelief of the market's credulity on this one. Yesterday, I wrote that Washington has no credibility on Wall Street, given that the House sandbagged the market, voting down TARP. I was wrong. Apparently Washington has a great deal of credibility on Wall Street, despite getting blindsided yesterday. I want Washington to do something, but there is a part of me that would like to see this fail just to wring the gullibility out of Wall Street. If the legislators fail and a bill does not pass and the market falls another 1000 points, then Wall Street will have no one to blame but themselves.
3. Suspension of mark-to-market accounting
Investors were under the impression that mark-to-market accounting, FASB 157, would be suspended. The SEC released a statement clarifying the interpretation of mark-to-market but did not say it would be suspended. The idea is that banks would not have to mark down their assets to recent market transactions if FASB 157 were suspended. The proponents argue that current market transactions represent distressed sales and not the true value of the underlying assets, but companies have to mark their assets to those unrealistic levels. Suspending the accounting rule will stop the death spiral of financial companies.
I think this is a canard. It would be yet another gimmick akin to suspending short selling. Financial companies are not collapsing because of mark-to-market accounting. They are collapsing because they did really dumb things and took on too much debt. Investors aren't stupid. Increasing opacity in the financial statements does not help investors understand the risks of the company in which they are investing. Compare the likes of AIG, Freddie Mac, Fannie Mae, Bear Stearns, IndyMac, and Lehman with the likes of US Bancorp and Wells Fargo. The former collapsed because they made bad business decisions whereas the latter are near 52 week highs because they didn't over-lever their balance sheets and make stupid investments.
Also, there are pools of capital out there waiting to invest in distressed assets. However, few transactions have occurred. Many of these pools of capital have long-term lock-ups of three or more years. They can handle the volatility of mark-to-market accounting if distressed sales are below intrinsic value because their investors cannot call their capital. Yet, few transactions are being done. Why? Could it be that the funds do not believe that the assets for sale are ridiculously cheap?
4. Stocks did not collapse so traders bought.
This is perhaps the most discouraging reason for the market's gain today. The willingness to buy in front of news after a hard down day does not seem to me to be behaviour one sees at the bottom. I would have preferred that investors puked out stocks rather than believe Washington will come to their rescue and buy the dips hopefully.
5. The possibility of an increase in FDIC insurance.
Today, the government of Ireland guaranteed bank deposits. There was chatter that the FDIC may increase insurance from $100,000 to $250,000. Some were saying that deposit insurance may become unlimited. Never mind that the FDIC might not be capitalized enough to handle all the bank failures to come, the government stepping up to guarantee all deposits was probably the single most bullish news today as it would make bank runs less likely. It could tank the dollar, but there are so many factors that could also tank the dollar, what's another one, eh?
6. ECB rate cut
Rumours had it that the ECB would cut rates soon. This very well may be true. The bank will start cutting rates shortly. Given the incredible stresses on the financial system, the rate cut may come sooner rather than later.
7. Money market pressures ease.
Slightly. The TED spread was over 3.5% today before easing to 3.15%, still very high but not as high as earlier in the day. The 3-month Treasury bill oscillated between 0.5% and 1% while swap spreads, though still high, were lower than yesterday. The Fed has pushed in an enormous amount of liquidity over the past few weeks to meet the insatiable demand for dollars. You could see the tremendous volatility in the Fed funds market, with rates as high as 7% this morning and falling to 0.125% this afternoon. Such volatility has been the norm as of late. This is why I'm not sure rate cuts by the Fed would be helpful in the near term.
8. Better than expected economic news
Forgotten by many was that the Chicago PMI and the Conference Board's consumer confidence index came in better than expected this morning.
9. Month and quarter end.
Month and quarter ends often bring unusual activity.
Volume was lighter than yesterday. Upside volume was 9.1:1 to downside volume, good but was dwarfed by Monday's 26.5:1 volume to the downside. It appears that the rally merely brings the indices back to within range where one would expect the market to start selling off again.
I keep hearing investors claim the market is cheap. I do not think so. I use $75 as my normalized earnings estimate, assuming a 7.5% margin, which is well above the long-term average of 6%. At $75, the market is trading at 15.5x earnings. That is not cheap. It is not expensive but it is not where bear markets have historically bottomed.
The average bear market since World War II has generated losses of 28%. To the lows yesterday, the market was down 30%, top to bottom. I contend that the worst credit crisis since the Depression will not lead to an average bear market in stocks.
The two worst bear markets during this time were 1973-74 and 2000-02, both of which saw declines of 50%. I do not think the decline in this bear market will be 50%, but instead will be somewhere between 30% and 50%. I'll pick 40% because it is a nice round number, which would take us to around 1000 on the S&P 500.
I do not know if the near-term bottom is in but I highly doubt the ultimate bottom is in. Thus, rallies remain to be sold.
SP500 to 1000 as bottom
After experiencing the worst one day loss on Monday since the market crash on October 19, 1987, markets rallied hard, with the Dow closing up nearly 500 points. There were several reasons for the gain.
1. The market was oversold
When only one stock in the S&P 500 goes up and the downside volume to upside volume is 26.5:1, as it was on Monday, a snapback rally is no surprise.
2. Belief that the government will still bail out the market.
This was the main reason why the market was up. Frankly, I am in disbelief of the market's credulity on this one. Yesterday, I wrote that Washington has no credibility on Wall Street, given that the House sandbagged the market, voting down TARP. I was wrong. Apparently Washington has a great deal of credibility on Wall Street, despite getting blindsided yesterday. I want Washington to do something, but there is a part of me that would like to see this fail just to wring the gullibility out of Wall Street. If the legislators fail and a bill does not pass and the market falls another 1000 points, then Wall Street will have no one to blame but themselves.
3. Suspension of mark-to-market accounting
Investors were under the impression that mark-to-market accounting, FASB 157, would be suspended. The SEC released a statement clarifying the interpretation of mark-to-market but did not say it would be suspended. The idea is that banks would not have to mark down their assets to recent market transactions if FASB 157 were suspended. The proponents argue that current market transactions represent distressed sales and not the true value of the underlying assets, but companies have to mark their assets to those unrealistic levels. Suspending the accounting rule will stop the death spiral of financial companies.
I think this is a canard. It would be yet another gimmick akin to suspending short selling. Financial companies are not collapsing because of mark-to-market accounting. They are collapsing because they did really dumb things and took on too much debt. Investors aren't stupid. Increasing opacity in the financial statements does not help investors understand the risks of the company in which they are investing. Compare the likes of AIG, Freddie Mac, Fannie Mae, Bear Stearns, IndyMac, and Lehman with the likes of US Bancorp and Wells Fargo. The former collapsed because they made bad business decisions whereas the latter are near 52 week highs because they didn't over-lever their balance sheets and make stupid investments.
Also, there are pools of capital out there waiting to invest in distressed assets. However, few transactions have occurred. Many of these pools of capital have long-term lock-ups of three or more years. They can handle the volatility of mark-to-market accounting if distressed sales are below intrinsic value because their investors cannot call their capital. Yet, few transactions are being done. Why? Could it be that the funds do not believe that the assets for sale are ridiculously cheap?
4. Stocks did not collapse so traders bought.
This is perhaps the most discouraging reason for the market's gain today. The willingness to buy in front of news after a hard down day does not seem to me to be behaviour one sees at the bottom. I would have preferred that investors puked out stocks rather than believe Washington will come to their rescue and buy the dips hopefully.
5. The possibility of an increase in FDIC insurance.
Today, the government of Ireland guaranteed bank deposits. There was chatter that the FDIC may increase insurance from $100,000 to $250,000. Some were saying that deposit insurance may become unlimited. Never mind that the FDIC might not be capitalized enough to handle all the bank failures to come, the government stepping up to guarantee all deposits was probably the single most bullish news today as it would make bank runs less likely. It could tank the dollar, but there are so many factors that could also tank the dollar, what's another one, eh?
6. ECB rate cut
Rumours had it that the ECB would cut rates soon. This very well may be true. The bank will start cutting rates shortly. Given the incredible stresses on the financial system, the rate cut may come sooner rather than later.
7. Money market pressures ease.
Slightly. The TED spread was over 3.5% today before easing to 3.15%, still very high but not as high as earlier in the day. The 3-month Treasury bill oscillated between 0.5% and 1% while swap spreads, though still high, were lower than yesterday. The Fed has pushed in an enormous amount of liquidity over the past few weeks to meet the insatiable demand for dollars. You could see the tremendous volatility in the Fed funds market, with rates as high as 7% this morning and falling to 0.125% this afternoon. Such volatility has been the norm as of late. This is why I'm not sure rate cuts by the Fed would be helpful in the near term.
8. Better than expected economic news
Forgotten by many was that the Chicago PMI and the Conference Board's consumer confidence index came in better than expected this morning.
9. Month and quarter end.
Month and quarter ends often bring unusual activity.
Volume was lighter than yesterday. Upside volume was 9.1:1 to downside volume, good but was dwarfed by Monday's 26.5:1 volume to the downside. It appears that the rally merely brings the indices back to within range where one would expect the market to start selling off again.
I keep hearing investors claim the market is cheap. I do not think so. I use $75 as my normalized earnings estimate, assuming a 7.5% margin, which is well above the long-term average of 6%. At $75, the market is trading at 15.5x earnings. That is not cheap. It is not expensive but it is not where bear markets have historically bottomed.
The average bear market since World War II has generated losses of 28%. To the lows yesterday, the market was down 30%, top to bottom. I contend that the worst credit crisis since the Depression will not lead to an average bear market in stocks.
The two worst bear markets during this time were 1973-74 and 2000-02, both of which saw declines of 50%. I do not think the decline in this bear market will be 50%, but instead will be somewhere between 30% and 50%. I'll pick 40% because it is a nice round number, which would take us to around 1000 on the S&P 500.
I do not know if the near-term bottom is in but I highly doubt the ultimate bottom is in. Thus, rallies remain to be sold.
1. The market was oversold
When only one stock in the S&P 500 goes up and the downside volume to upside volume is 26.5:1, as it was on Monday, a snapback rally is no surprise.
2. Belief that the government will still bail out the market.
This was the main reason why the market was up. Frankly, I am in disbelief of the market's credulity on this one. Yesterday, I wrote that Washington has no credibility on Wall Street, given that the House sandbagged the market, voting down TARP. I was wrong. Apparently Washington has a great deal of credibility on Wall Street, despite getting blindsided yesterday. I want Washington to do something, but there is a part of me that would like to see this fail just to wring the gullibility out of Wall Street. If the legislators fail and a bill does not pass and the market falls another 1000 points, then Wall Street will have no one to blame but themselves.
3. Suspension of mark-to-market accounting
Investors were under the impression that mark-to-market accounting, FASB 157, would be suspended. The SEC released a statement clarifying the interpretation of mark-to-market but did not say it would be suspended. The idea is that banks would not have to mark down their assets to recent market transactions if FASB 157 were suspended. The proponents argue that current market transactions represent distressed sales and not the true value of the underlying assets, but companies have to mark their assets to those unrealistic levels. Suspending the accounting rule will stop the death spiral of financial companies.
I think this is a canard. It would be yet another gimmick akin to suspending short selling. Financial companies are not collapsing because of mark-to-market accounting. They are collapsing because they did really dumb things and took on too much debt. Investors aren't stupid. Increasing opacity in the financial statements does not help investors understand the risks of the company in which they are investing. Compare the likes of AIG, Freddie Mac, Fannie Mae, Bear Stearns, IndyMac, and Lehman with the likes of US Bancorp and Wells Fargo. The former collapsed because they made bad business decisions whereas the latter are near 52 week highs because they didn't over-lever their balance sheets and make stupid investments.
Also, there are pools of capital out there waiting to invest in distressed assets. However, few transactions have occurred. Many of these pools of capital have long-term lock-ups of three or more years. They can handle the volatility of mark-to-market accounting if distressed sales are below intrinsic value because their investors cannot call their capital. Yet, few transactions are being done. Why? Could it be that the funds do not believe that the assets for sale are ridiculously cheap?
4. Stocks did not collapse so traders bought.
This is perhaps the most discouraging reason for the market's gain today. The willingness to buy in front of news after a hard down day does not seem to me to be behaviour one sees at the bottom. I would have preferred that investors puked out stocks rather than believe Washington will come to their rescue and buy the dips hopefully.
5. The possibility of an increase in FDIC insurance.
Today, the government of Ireland guaranteed bank deposits. There was chatter that the FDIC may increase insurance from $100,000 to $250,000. Some were saying that deposit insurance may become unlimited. Never mind that the FDIC might not be capitalized enough to handle all the bank failures to come, the government stepping up to guarantee all deposits was probably the single most bullish news today as it would make bank runs less likely. It could tank the dollar, but there are so many factors that could also tank the dollar, what's another one, eh?
6. ECB rate cut
Rumours had it that the ECB would cut rates soon. This very well may be true. The bank will start cutting rates shortly. Given the incredible stresses on the financial system, the rate cut may come sooner rather than later.
7. Money market pressures ease.
Slightly. The TED spread was over 3.5% today before easing to 3.15%, still very high but not as high as earlier in the day. The 3-month Treasury bill oscillated between 0.5% and 1% while swap spreads, though still high, were lower than yesterday. The Fed has pushed in an enormous amount of liquidity over the past few weeks to meet the insatiable demand for dollars. You could see the tremendous volatility in the Fed funds market, with rates as high as 7% this morning and falling to 0.125% this afternoon. Such volatility has been the norm as of late. This is why I'm not sure rate cuts by the Fed would be helpful in the near term.
8. Better than expected economic news
Forgotten by many was that the Chicago PMI and the Conference Board's consumer confidence index came in better than expected this morning.
9. Month and quarter end.
Month and quarter ends often bring unusual activity.
Volume was lighter than yesterday. Upside volume was 9.1:1 to downside volume, good but was dwarfed by Monday's 26.5:1 volume to the downside. It appears that the rally merely brings the indices back to within range where one would expect the market to start selling off again.
I keep hearing investors claim the market is cheap. I do not think so. I use $75 as my normalized earnings estimate, assuming a 7.5% margin, which is well above the long-term average of 6%. At $75, the market is trading at 15.5x earnings. That is not cheap. It is not expensive but it is not where bear markets have historically bottomed.
The average bear market since World War II has generated losses of 28%. To the lows yesterday, the market was down 30%, top to bottom. I contend that the worst credit crisis since the Depression will not lead to an average bear market in stocks.
The two worst bear markets during this time were 1973-74 and 2000-02, both of which saw declines of 50%. I do not think the decline in this bear market will be 50%, but instead will be somewhere between 30% and 50%. I'll pick 40% because it is a nice round number, which would take us to around 1000 on the S&P 500.
I do not know if the near-term bottom is in but I highly doubt the ultimate bottom is in. Thus, rallies remain to be sold.
Monday, September 29, 2008
-777.7 Shorters all hit a big lottery
Today was an amazing day.
I truly did not expect the house to kill the bailout bill.
Neither did the market, as the Dow dropped 777.7 points, the worst one day decline since the 1987 crash.
The leaders of the country played a stunning game of political brinkmanship, with the majority of Republicans voting against the bill, in part due to a stridently partisan speech given by Nancy Pelosi.
Blame is to be had on all sides. The Democrats tried to attach amendments to the bill having nothing to do with the crisis which would instead satisfy their backers, such as passing laws forcing boards to have union representation.
The Republicans were no better. Tonight on CNBC's Fast Money, a Texas GOP Congressman who voted against the bill offered several so-called free market solutions to the credit crisis, one of which was cutting capital gains taxes, a mind-boggling display of economic cluelessness and/or craven ideological and political pandering.
The White House also deserves more than its fair share of blame. For so long, the mantra from Bush and Co. was that the economy was fundamentally strong. The Bush administration's disdain and contempt for others who were not onside bred suspicion and hostility, such that the White House no longer has the moral suasion to lead when leadership is most required. Given the administration's lack of credibility, it is not surprising Congress would be highly skeptical of the White House, especially when the original proposal appeared to abrogate the constitution.
However, the reason why the House failed to pass the bill was that constituents were overwhelmingly against it. Representatives in swing states voted against the bill, fearing they would lose their seats in November.
Well, democracy is messy, but The People may have sealed their own fate. C'est la vie. That is their right. But whatever one might have thought about the bill, the markets - both stocks and credit - certainly hated that it failed to pass.
Perhaps over the long run, the bill's failure is a good thing. It may be that a purging of the markets will clean out the excesses so rampant in the financial system today.
Or, it may induce a terrible crash and reductions in credit, with tremendous ramifications throughout the broad economy.
There has been talk in certain quarters of another 1930s-style Depression. That will not happen. There are too many structural stabilizers in the system to prevent such a catastrophe. But we could experience a sharp recession.
If we do have a significant economic contraction, this is the recession we should have had after the collapse of the Tech Bubble. At the time, the authorities made a conscious decision to implement policies to avoid a severe recession, particularly Alan Greenspan's decision to lower the Fed funds target to 1% and keep it there. However, fiscal policy and the decision to give Americans a massive tax cut without any reductions in spending also contributed to this mess.
The primary effects of these policies were to push the pain further into the future, and to create even bigger problems in the housing and debt markets. Now, the chickens have come home to roost, and the problems are far worse than if we had just taken our medicine during the early part of the decade.
So what to do now?
First, the market usually does not bottom the day after it closes on its lows. Thus, it is highly unlikely today was the bottom. Expect the market to fall further.
Second, it is my guess - and I strongly emphasize the word "guess" - that a near-term bottom is approaching in terms of time. In terms of return, I have no idea. I have no clue if the near-term bottom is 200 or 2000 points away. My intuition tells me that we are going to hit a bottom sometime within the next two weeks. But that does not mean there will not be acute pain before then.
Next, we are working without a net. Washington has no credibility on Wall Street. Despite the platitudes on television from the politicians tonight about getting a bill done, there is no reason to believe them, nor is there any reason to believe any new bill would be effective.
Now, I do not think that Paulson's plan would have stopped the rot in the system. But I do believe the bill would have cushioned the fall.
The effect of Paulson's bill, however, may have been to prolong the adjustment process, spreading the pain out over time. We may go through a traumatic period, but a shorter period compared to the Paulson plan, where the excesses are purged quicker. If so, this will ultimately be good for the market and the economy over the long-term.
Finally, in a bear market, the most important thing is to protect your capital. If you are long and cannot take the pain, get out. There will always be opportunities in the future.
The lower we go, though, the higher the future returns become. Every drop in the market decreases the values of stocks and increases the potential returns over time.
You have to decide where you are on this risk/return spectrum.
I am very, very short at the moment. I covered a small portion this afternoon and will be looking to cover more into further weakness.
I also intend to start adding to long-term positions. I believe that some stocks are getting to levels where historically, they have been doubles or triples a few years out.
But in the meantime, we are in unchartered waters.
I truly did not expect the house to kill the bailout bill.
Neither did the market, as the Dow dropped 777.7 points, the worst one day decline since the 1987 crash.
The leaders of the country played a stunning game of political brinkmanship, with the majority of Republicans voting against the bill, in part due to a stridently partisan speech given by Nancy Pelosi.
Blame is to be had on all sides. The Democrats tried to attach amendments to the bill having nothing to do with the crisis which would instead satisfy their backers, such as passing laws forcing boards to have union representation.
The Republicans were no better. Tonight on CNBC's Fast Money, a Texas GOP Congressman who voted against the bill offered several so-called free market solutions to the credit crisis, one of which was cutting capital gains taxes, a mind-boggling display of economic cluelessness and/or craven ideological and political pandering.
The White House also deserves more than its fair share of blame. For so long, the mantra from Bush and Co. was that the economy was fundamentally strong. The Bush administration's disdain and contempt for others who were not onside bred suspicion and hostility, such that the White House no longer has the moral suasion to lead when leadership is most required. Given the administration's lack of credibility, it is not surprising Congress would be highly skeptical of the White House, especially when the original proposal appeared to abrogate the constitution.
However, the reason why the House failed to pass the bill was that constituents were overwhelmingly against it. Representatives in swing states voted against the bill, fearing they would lose their seats in November.
Well, democracy is messy, but The People may have sealed their own fate. C'est la vie. That is their right. But whatever one might have thought about the bill, the markets - both stocks and credit - certainly hated that it failed to pass.
Perhaps over the long run, the bill's failure is a good thing. It may be that a purging of the markets will clean out the excesses so rampant in the financial system today.
Or, it may induce a terrible crash and reductions in credit, with tremendous ramifications throughout the broad economy.
There has been talk in certain quarters of another 1930s-style Depression. That will not happen. There are too many structural stabilizers in the system to prevent such a catastrophe. But we could experience a sharp recession.
If we do have a significant economic contraction, this is the recession we should have had after the collapse of the Tech Bubble. At the time, the authorities made a conscious decision to implement policies to avoid a severe recession, particularly Alan Greenspan's decision to lower the Fed funds target to 1% and keep it there. However, fiscal policy and the decision to give Americans a massive tax cut without any reductions in spending also contributed to this mess.
The primary effects of these policies were to push the pain further into the future, and to create even bigger problems in the housing and debt markets. Now, the chickens have come home to roost, and the problems are far worse than if we had just taken our medicine during the early part of the decade.
So what to do now?
First, the market usually does not bottom the day after it closes on its lows. Thus, it is highly unlikely today was the bottom. Expect the market to fall further.
Second, it is my guess - and I strongly emphasize the word "guess" - that a near-term bottom is approaching in terms of time. In terms of return, I have no idea. I have no clue if the near-term bottom is 200 or 2000 points away. My intuition tells me that we are going to hit a bottom sometime within the next two weeks. But that does not mean there will not be acute pain before then.
Next, we are working without a net. Washington has no credibility on Wall Street. Despite the platitudes on television from the politicians tonight about getting a bill done, there is no reason to believe them, nor is there any reason to believe any new bill would be effective.
Now, I do not think that Paulson's plan would have stopped the rot in the system. But I do believe the bill would have cushioned the fall.
The effect of Paulson's bill, however, may have been to prolong the adjustment process, spreading the pain out over time. We may go through a traumatic period, but a shorter period compared to the Paulson plan, where the excesses are purged quicker. If so, this will ultimately be good for the market and the economy over the long-term.
Finally, in a bear market, the most important thing is to protect your capital. If you are long and cannot take the pain, get out. There will always be opportunities in the future.
The lower we go, though, the higher the future returns become. Every drop in the market decreases the values of stocks and increases the potential returns over time.
You have to decide where you are on this risk/return spectrum.
I am very, very short at the moment. I covered a small portion this afternoon and will be looking to cover more into further weakness.
I also intend to start adding to long-term positions. I believe that some stocks are getting to levels where historically, they have been doubles or triples a few years out.
But in the meantime, we are in unchartered waters.
Saturday, September 27, 2008
Marc Faber Report Card
Let's talk about interest rates. Marc, you've been uncharacteristically quiet. Aren't you feeling well?
Faber: I am well and happy because I talked about many of these issues a year ago and recommended shorting the brokers. Subprime is a symptom of a much wider problem: the huge credit bubble built over the past 25 years. It is just the appetizer to something bigger, which will lead to relative illiquidity in the world. I travel around the world regularly, and every place I've gone has had a boom. The U.S. already would be in recession if government statistics were correct. The rest of the world will see a meaningful slowdown because global financial connectivity is greater than ever before.
The Fed brought about the latest boom by cutting the federal-funds rate from 6.5% in January 2001 to 1%. It kept fed funds at 1% until June 2004, even though the recovery in the U.S. began in November 2001. In other words, almost three years into a recovery [then-Fed Chairman] Alan Greenspan still had the fed-funds rate at 1%. This led to huge liquidity in the system -- asset bubbles, debt growth and growth in the trade and current-account deficits. Now those deficits are shrinking. This is an unfriendly environment for economic growth, financial markets and even industrial commodities. But it is friendly for the U.S. dollar.
Faber: I took a taxi from Times Square to lower Manhattan this morning and paid $14. In Europe the ride would have cost me three times as much. Prices in the U.S. are relatively inexpensive, as Abby learned at breakfast in Paris. This reminds me of other economies in which prices became low and inflation picked up. The taxi driver will increase his price massively sooner or later. Let me stress that weak currencies don't produce inflation. Inflation in the system produces a weak currency.
Faber: U.S. exports have gone up a bit, especially because of price increases in agricultural commodities and some capital goods. But the number of inbound and arriving containers at U.S. ports is down year on year, as are rail-car loadings. The trucking index is down. These statistics point to a recession in the U.S.
Faber: Scott, your fiscal policy will be another disaster superimposed on a disastrous monetary policy.
Faber: The average citizen will be in a recession anyway, because inflation will be higher than the benefits he gets from the tax cuts you propose. I also see a stagflation scenario similar to the 1970s, with high volatility in financial markets. Corporate earnings get squeezed nicely, with S&P earnings falling
Faber: U.S. policy is misguided in targeting consumption, not investments.
Faber: Equity prices have increased in dollar terms, but in euros the S&P 500 is down about 45% from its peak in 2000 and the Nasdaq is down 60%. Measured in gold, the markets have done horribly and the economy has been in a recession for a long time. I'm not bullish about U.S. stocks, but everything is so bad on a global basis that they might do better on a relative basis. That doesn't mean they go up, but the U.S. market might go down less than China, India, Vietnam and some of the other markets that are in cuckoo land. These markets have gone up because people believe in decoupling. Economically we could see a decoupling, whereby the U.S. is in a recession and China still grows by 5% or 10%. The financial markets won't decouple. Unless, Mario, they reintroduce that uptick rule.
Five years ago I visited family offices and financial institutions that had practically no exposure to international stocks. Today the same people have 50% of their money in emerging markets. Valuations in these markets aren't compelling any more, except for real estate in emerging economies.
Marc, what do you think of gold?
Faber: There are times when stocks do fantastically well and there are times when commodities do well. On a relative basis, gold became unbelievably inexpensive in the years 1999 to 2001. Now, prices have gone up. We had a bubble in Japan in 1989. Then we had the Nasdaq bubble, and bubbles in countries like China, and in the credit markets. The last big bubble to burst will be gold.
Black: If gold rallies at least 15%, to $1,000 an ounce, wouldn't it be better to buy an exploration and production company that could rally more?
Faber: Not necessarily. You want to own gold because you think something will go wrong, leading to deflation or hyperinflation. Mines can be expropriated. Also, exploration companies are like biotechnology and nanotechnology companies. One in a hundred will succeed.
Faber: A company like this is likely to be bought by a major miner, because the majors, like big pharmaceutical companies, don't spend much on research. They would rather buy
Marc, man of the world and proprietor of Marc Faber Ltd. in Hong Kong, says all asset markets are oversold "in the very short term" and due to rebound strongly, although he doubts they'll go to new highs. Equity investors, he grouses, still are focused on buying the dips, not selling the bounces, and sentiment is negative not because they have liquidated their shares, but because they're sitting on large losses. Emerging markets, he adds, have "considerable downside risk," but recoveries of 10% to 15% are common in bear markets. Marc's picks this year are mostly pans -- of several currencies and emerging-market shares.
2008 Barron's Roundtable Members
Marc Faber, Managing director, Marc Faber Ltd., Hong Kong
Thanks, Abby. Marc, what have you got for us?
Faber: We aren't dealing purely with market forces today, but with an economy that is largely manipulated by central banks, which create excess liquidity by cutting interest rates dramatically and letting credit growth accelerate dramatically. I'd like to read a quote from a German newspaper published in 1923, when Germany was dealing with hyperinflation: 'There have been extraordinary rises in the quotations for all shares, the chief cause being the catastrophic change in the economic situation.' In other words, you could have a slump in the economy, yet share markets could go up simply because of excessive liquidity and interest rates being cut, theoretically, to zero.
Since 2002, all asset prices have risen substantially. Against this backdrop, I'll focus on pair trades -- assets that will perform better in the next three to six months relative to others. The U.S. is in a bear market, and earnings will disappoint here and worldwide. Cost pressures will diminish profit margins. The stock market doesn't have a bubble valuation, though the Standard & Poor's 500 is selling at a higher price-earnings multiple than is evident. Take out the energy sector and the S&P has a P/E of 20, not 15. If earnings decline -- partly because the energy sector won't have higher earnings this year than last, and also because the financial sector has diminishing earnings and the economy is in a recession -- then the S&P isn't cheap.
Cohen: If you were to sector-weight the S&P with the same sector weights as in Europe, the P/Es are identical.
Faber: I didn't say Europe is cheap. Stocks in the U.S. probably are cheaper than 10-year Treasuries. Cash has been a disastrous investment for the past 40 years because the purchasing power of money has diminished. I don't find any great values in the stock market now. If people want to buy stocks, stick to the recommendations I made last year. [You'll find them listed free of charge on Barron's Online, www.barrons.com, under the 2007 Roundtable Report Card.]
I still like gold, cotton and sugar. My new recommendation is to short the British pound against the yen. The pound, as Felix explained, is overvalued. It doesn't have a lot of upside potential compared to the dollar. It is probably less risky to short it against the yen than the dollar. [The pound has fallen 3.3% against the yen since Jan. 7. Faber remains short the pound.]
You can also short the euro against the yen. The euro is a relatively expensive currency and European economies aren't going to perform well. Europe also had a lot of excesses, and the ECB [European Central Bank] will cut rates dramatically. Central-bank monetary policies are leading to the competitive devaluation of currencies.
Zulauf: Which is good for gold.
Faber: I suppose so. Since 2001, emerging stock markets have significantly outperformed the U.S. It's not that I am bullish about the S&P 500 or the Dow Jones [industrial average], but they may go down less than emerging markets. If there's a strong rally in financial assets, it could be that the Dow outperforms emerging markets. I would short an emerging-market index via the ProShares Short MSCI Emerging Markets exchange-traded fund. You could also short the FXI, the iShares FTSE/Xinhua China 25, which mimics the 25 largest Chinese stocks listed in Hong Kong and China. And, there's an ETF, the ProShares UltraShort FTSE/Xinhua China 25, which appreciates twice as much when the Chinese market goes down.
In the long run, the U.S. dollar will go down, but because of the diminishing current-account deficit, it doesn't have huge downside risk now. Negative sentiment on the dollar reached an extreme recently, with many front-page articles noting its decline.
Sentiment on the dollar was very bearish a year ago, too. Sentiment in this case didn't count.
Faber: It has reached extremes. It also has depreciated considerably against the euro. Today, I would buy the dollar.
At the moment, there is a war: The private sector is cutting credit and the central banks are cutting interest rates because they are desperate to revitalize credit growth. In the long run, the central banks will win, but in the next six to 12 months, relative credit contraction isn't going to be good for any asset class. In a year's time, the S&P 500 will be lower than it is today.
Marc Faber's Picks 1/4/08
Investment Ticker Price Currency Pair Trades
Short the British pound/Buy the Yen £1=¥211.97
Short the Euro/Buy the Yen €1=¥160.09
Buy the U.S. Dollar /Sell the Euro €1=$1.47
Short Emerging Markets
Buy: ProShares Short MSCI Emerging Mkt.
EUM $75.40
Short: iShares FTSE/Xinhua China 25 Index
FXI 163.61
Buy: ProShares UltraSht FTSE/Xinhua China 25
FXP 82.51
Buy
iShares MSCI Japan Small Cap*
SCJ $49.94
Short
DryShips
DRYS 73.17
Future Investment Opportunities:
Cambodia
*Buy after a 10% correction.
Source: Bloomberg
My next recommendation is a shipping short. I turned bearish about home-building stocks in 2005, and felt the troubles in the housing market would hurt the subprime-lending industry and spread to other sectors of the economy -- in particular, consumption. Private consumption now accounts for more than 70% of U.S. GDP, which is why I'm negative about the U.S. economy. The problems here will also affect other economies. The Chinese stock market is closely correlated with the Baltic Dry Index, a shipping index. Tanker rates have plunged, but the Baltic Dry Index is still in the sky. If you can't short the index, short DryShips [DRYS]. The BDI has fallen 28% since Jan. 7. Faber suggests remaining short DryShips.
Any other ideas, Marc?
Faber: Two trades today are totally out of favor. One is betting on the dollar, and the other is buying Japanese shares. I go to seminars, and whereas 10, 15 years ago there were hundreds of people attending the Japanese sessions, today there are hundreds attending sessions on investing in Vietnam. Nobody goes to the Japanese sessions anymore. It's remarkable that people talk about equity valuations being low in the U.S. compared with bond yields, while valuations in Japan are very low compared to the Japanese bond yield. Buy the Japanese stock market on a correction of 10% or so.
What would you buy?
Faber: Give your money to a good money manager, or just buy the index. The small-cap index is interesting. You can buy the iShares MSCI Japan Small Cap Index, an ETF.
Faber: Many countries have opened up following the breakdowns of communism and socialism. China began opening in 1978, proceeding at different times and in different sectors. The same has occurred since the late '90s in India, and more recently, Vietnam. One country in Asia hasn't begun to attract a lot of attention, but has great potential. It is Cambodia. You can't play Cambodia now, but some Cambodia funds will be launched this year.
Eastern Europe has climbed the value scale. There isn't a big difference anymore between, say, Slovenia and Austria. Go further east, into Ukraine, and you'll find big opportunities in real estate, in particular agricultural land.
Basically, investors should avoid correlated assets such as the S&P 500 and the FTSE index, emerging markets, art prices and real estate in financial centers. I'm ultra-bearish about the financial sector, as it will contract for many years, not just one year. I wouldn't buy Citigroup [C] here, or Merrill Lynch [MER]. And as much as I like Abby, I wouldn't buy Goldman Sachs [GS]. I anticipate the day when half of Wall Street will be looking for jobs as drivers of tractors and combine machines.
Faber: I am well and happy because I talked about many of these issues a year ago and recommended shorting the brokers. Subprime is a symptom of a much wider problem: the huge credit bubble built over the past 25 years. It is just the appetizer to something bigger, which will lead to relative illiquidity in the world. I travel around the world regularly, and every place I've gone has had a boom. The U.S. already would be in recession if government statistics were correct. The rest of the world will see a meaningful slowdown because global financial connectivity is greater than ever before.
The Fed brought about the latest boom by cutting the federal-funds rate from 6.5% in January 2001 to 1%. It kept fed funds at 1% until June 2004, even though the recovery in the U.S. began in November 2001. In other words, almost three years into a recovery [then-Fed Chairman] Alan Greenspan still had the fed-funds rate at 1%. This led to huge liquidity in the system -- asset bubbles, debt growth and growth in the trade and current-account deficits. Now those deficits are shrinking. This is an unfriendly environment for economic growth, financial markets and even industrial commodities. But it is friendly for the U.S. dollar.
Faber: I took a taxi from Times Square to lower Manhattan this morning and paid $14. In Europe the ride would have cost me three times as much. Prices in the U.S. are relatively inexpensive, as Abby learned at breakfast in Paris. This reminds me of other economies in which prices became low and inflation picked up. The taxi driver will increase his price massively sooner or later. Let me stress that weak currencies don't produce inflation. Inflation in the system produces a weak currency.
Faber: U.S. exports have gone up a bit, especially because of price increases in agricultural commodities and some capital goods. But the number of inbound and arriving containers at U.S. ports is down year on year, as are rail-car loadings. The trucking index is down. These statistics point to a recession in the U.S.
Faber: Scott, your fiscal policy will be another disaster superimposed on a disastrous monetary policy.
Faber: The average citizen will be in a recession anyway, because inflation will be higher than the benefits he gets from the tax cuts you propose. I also see a stagflation scenario similar to the 1970s, with high volatility in financial markets. Corporate earnings get squeezed nicely, with S&P earnings falling
Faber: U.S. policy is misguided in targeting consumption, not investments.
Faber: Equity prices have increased in dollar terms, but in euros the S&P 500 is down about 45% from its peak in 2000 and the Nasdaq is down 60%. Measured in gold, the markets have done horribly and the economy has been in a recession for a long time. I'm not bullish about U.S. stocks, but everything is so bad on a global basis that they might do better on a relative basis. That doesn't mean they go up, but the U.S. market might go down less than China, India, Vietnam and some of the other markets that are in cuckoo land. These markets have gone up because people believe in decoupling. Economically we could see a decoupling, whereby the U.S. is in a recession and China still grows by 5% or 10%. The financial markets won't decouple. Unless, Mario, they reintroduce that uptick rule.
Five years ago I visited family offices and financial institutions that had practically no exposure to international stocks. Today the same people have 50% of their money in emerging markets. Valuations in these markets aren't compelling any more, except for real estate in emerging economies.
Marc, what do you think of gold?
Faber: There are times when stocks do fantastically well and there are times when commodities do well. On a relative basis, gold became unbelievably inexpensive in the years 1999 to 2001. Now, prices have gone up. We had a bubble in Japan in 1989. Then we had the Nasdaq bubble, and bubbles in countries like China, and in the credit markets. The last big bubble to burst will be gold.
Black: If gold rallies at least 15%, to $1,000 an ounce, wouldn't it be better to buy an exploration and production company that could rally more?
Faber: Not necessarily. You want to own gold because you think something will go wrong, leading to deflation or hyperinflation. Mines can be expropriated. Also, exploration companies are like biotechnology and nanotechnology companies. One in a hundred will succeed.
Faber: A company like this is likely to be bought by a major miner, because the majors, like big pharmaceutical companies, don't spend much on research. They would rather buy
Marc, man of the world and proprietor of Marc Faber Ltd. in Hong Kong, says all asset markets are oversold "in the very short term" and due to rebound strongly, although he doubts they'll go to new highs. Equity investors, he grouses, still are focused on buying the dips, not selling the bounces, and sentiment is negative not because they have liquidated their shares, but because they're sitting on large losses. Emerging markets, he adds, have "considerable downside risk," but recoveries of 10% to 15% are common in bear markets. Marc's picks this year are mostly pans -- of several currencies and emerging-market shares.
2008 Barron's Roundtable Members
Marc Faber, Managing director, Marc Faber Ltd., Hong Kong
Thanks, Abby. Marc, what have you got for us?
Faber: We aren't dealing purely with market forces today, but with an economy that is largely manipulated by central banks, which create excess liquidity by cutting interest rates dramatically and letting credit growth accelerate dramatically. I'd like to read a quote from a German newspaper published in 1923, when Germany was dealing with hyperinflation: 'There have been extraordinary rises in the quotations for all shares, the chief cause being the catastrophic change in the economic situation.' In other words, you could have a slump in the economy, yet share markets could go up simply because of excessive liquidity and interest rates being cut, theoretically, to zero.
Since 2002, all asset prices have risen substantially. Against this backdrop, I'll focus on pair trades -- assets that will perform better in the next three to six months relative to others. The U.S. is in a bear market, and earnings will disappoint here and worldwide. Cost pressures will diminish profit margins. The stock market doesn't have a bubble valuation, though the Standard & Poor's 500 is selling at a higher price-earnings multiple than is evident. Take out the energy sector and the S&P has a P/E of 20, not 15. If earnings decline -- partly because the energy sector won't have higher earnings this year than last, and also because the financial sector has diminishing earnings and the economy is in a recession -- then the S&P isn't cheap.
Cohen: If you were to sector-weight the S&P with the same sector weights as in Europe, the P/Es are identical.
Faber: I didn't say Europe is cheap. Stocks in the U.S. probably are cheaper than 10-year Treasuries. Cash has been a disastrous investment for the past 40 years because the purchasing power of money has diminished. I don't find any great values in the stock market now. If people want to buy stocks, stick to the recommendations I made last year. [You'll find them listed free of charge on Barron's Online, www.barrons.com, under the 2007 Roundtable Report Card.]
I still like gold, cotton and sugar. My new recommendation is to short the British pound against the yen. The pound, as Felix explained, is overvalued. It doesn't have a lot of upside potential compared to the dollar. It is probably less risky to short it against the yen than the dollar. [The pound has fallen 3.3% against the yen since Jan. 7. Faber remains short the pound.]
You can also short the euro against the yen. The euro is a relatively expensive currency and European economies aren't going to perform well. Europe also had a lot of excesses, and the ECB [European Central Bank] will cut rates dramatically. Central-bank monetary policies are leading to the competitive devaluation of currencies.
Zulauf: Which is good for gold.
Faber: I suppose so. Since 2001, emerging stock markets have significantly outperformed the U.S. It's not that I am bullish about the S&P 500 or the Dow Jones [industrial average], but they may go down less than emerging markets. If there's a strong rally in financial assets, it could be that the Dow outperforms emerging markets. I would short an emerging-market index via the ProShares Short MSCI Emerging Markets exchange-traded fund. You could also short the FXI, the iShares FTSE/Xinhua China 25, which mimics the 25 largest Chinese stocks listed in Hong Kong and China. And, there's an ETF, the ProShares UltraShort FTSE/Xinhua China 25, which appreciates twice as much when the Chinese market goes down.
In the long run, the U.S. dollar will go down, but because of the diminishing current-account deficit, it doesn't have huge downside risk now. Negative sentiment on the dollar reached an extreme recently, with many front-page articles noting its decline.
Sentiment on the dollar was very bearish a year ago, too. Sentiment in this case didn't count.
Faber: It has reached extremes. It also has depreciated considerably against the euro. Today, I would buy the dollar.
At the moment, there is a war: The private sector is cutting credit and the central banks are cutting interest rates because they are desperate to revitalize credit growth. In the long run, the central banks will win, but in the next six to 12 months, relative credit contraction isn't going to be good for any asset class. In a year's time, the S&P 500 will be lower than it is today.
Marc Faber's Picks 1/4/08
Investment Ticker Price Currency Pair Trades
Short the British pound/Buy the Yen £1=¥211.97
Short the Euro/Buy the Yen €1=¥160.09
Buy the U.S. Dollar /Sell the Euro €1=$1.47
Short Emerging Markets
Buy: ProShares Short MSCI Emerging Mkt.
EUM $75.40
Short: iShares FTSE/Xinhua China 25 Index
FXI 163.61
Buy: ProShares UltraSht FTSE/Xinhua China 25
FXP 82.51
Buy
iShares MSCI Japan Small Cap*
SCJ $49.94
Short
DryShips
DRYS 73.17
Future Investment Opportunities:
Cambodia
*Buy after a 10% correction.
Source: Bloomberg
My next recommendation is a shipping short. I turned bearish about home-building stocks in 2005, and felt the troubles in the housing market would hurt the subprime-lending industry and spread to other sectors of the economy -- in particular, consumption. Private consumption now accounts for more than 70% of U.S. GDP, which is why I'm negative about the U.S. economy. The problems here will also affect other economies. The Chinese stock market is closely correlated with the Baltic Dry Index, a shipping index. Tanker rates have plunged, but the Baltic Dry Index is still in the sky. If you can't short the index, short DryShips [DRYS]. The BDI has fallen 28% since Jan. 7. Faber suggests remaining short DryShips.
Any other ideas, Marc?
Faber: Two trades today are totally out of favor. One is betting on the dollar, and the other is buying Japanese shares. I go to seminars, and whereas 10, 15 years ago there were hundreds of people attending the Japanese sessions, today there are hundreds attending sessions on investing in Vietnam. Nobody goes to the Japanese sessions anymore. It's remarkable that people talk about equity valuations being low in the U.S. compared with bond yields, while valuations in Japan are very low compared to the Japanese bond yield. Buy the Japanese stock market on a correction of 10% or so.
What would you buy?
Faber: Give your money to a good money manager, or just buy the index. The small-cap index is interesting. You can buy the iShares MSCI Japan Small Cap Index, an ETF.
Faber: Many countries have opened up following the breakdowns of communism and socialism. China began opening in 1978, proceeding at different times and in different sectors. The same has occurred since the late '90s in India, and more recently, Vietnam. One country in Asia hasn't begun to attract a lot of attention, but has great potential. It is Cambodia. You can't play Cambodia now, but some Cambodia funds will be launched this year.
Eastern Europe has climbed the value scale. There isn't a big difference anymore between, say, Slovenia and Austria. Go further east, into Ukraine, and you'll find big opportunities in real estate, in particular agricultural land.
Basically, investors should avoid correlated assets such as the S&P 500 and the FTSE index, emerging markets, art prices and real estate in financial centers. I'm ultra-bearish about the financial sector, as it will contract for many years, not just one year. I wouldn't buy Citigroup [C] here, or Merrill Lynch [MER]. And as much as I like Abby, I wouldn't buy Goldman Sachs [GS]. I anticipate the day when half of Wall Street will be looking for jobs as drivers of tractors and combine machines.
Thursday, September 25, 2008
Banks vs Wall Street
Don't confuse speculators with the banks and Wall Street. There is an enormous gulf between the two. The fact is the banks did create loans and loan structures that encouraged excessive borrowing. Merrill used to encourage homeowners to take out home equity loans and put the money in stocks. Homeowners did not create option ARMs or understand them. Banks created then and sold them. The public did not slice, dice and engineer toxic securities from their mortgages. Wall Street did that.
Does the public have culpability for their stupidity and greed? Of course they do and they are paying for it. Look at foreclosures. That can't be a pleasant experience. However, the Street has to take its share of blame for creating the speculative fires and then pouring gas on them.
Most "speculators" had nothing to do with the creation of this mess. They do not lend money or create securities. They trade. And most of us do it with our own money.
Does the public have culpability for their stupidity and greed? Of course they do and they are paying for it. Look at foreclosures. That can't be a pleasant experience. However, the Street has to take its share of blame for creating the speculative fires and then pouring gas on them.
Most "speculators" had nothing to do with the creation of this mess. They do not lend money or create securities. They trade. And most of us do it with our own money.
Wednesday, September 24, 2008
Setting Main Street vs. Wall Street
The vilification of Wall Street is taking full force. It is the worst form of scapegoating, denial, and mistakes were made (but not by me). It is similar to the criticisms of the legal profession where the intransigence, unreasonableness, and greed of the litigants is blamed on the representatives who are doing the job set out for them in the system. The current crisis originated in the greed and failure to save by homeowners, their use of real estate borrowing for consumptive lifestyles. Their failure to save, their spendthrift ways are all being loaded on to the investment community who were doing their function within the system. Now emails are floating around fighting the bailout of billionaires on Wall Street. You are an easy scapegoat. No matter that the speculator helped provide the liquidity to create trillions in new wealth. No matter that the long held family home is valued at many multiples of it's purchase price. It is the most culpable real estate speculator and overextended consumer that now point the finger in the attempt to avoid their own errors, lack of judgment. With an election coming up, the politicians, the worst of all, are jumping on the BANDWAGON. The cycle is ending. The funny thing is that equities are barely down a 1/5 and they are throwing out the baby along with the bathwater. But it's good. We really don't need the big firms anymore with universal access and electronic execution. Truth is we really don't need big government either, but its turn comes next.
For the speculator, many new niches and many opportunity will arise. The government will be the ultimate slow mover. As they try to enter the market, as we have seen this last week, there are big waves kicked up. The least qualified populate government functions. Small and fast moving adaptors can thrive in such an environment. Seems that many big hedge funds are going down or weakening. The white shoe brokers are weak. The change will be good. It's just like evolution and climatic change. New species will arise. Many will perish unless they adapt. Even the data itself is reinventing itself with data over a year old being almost irrelevant. As Lack says, regulation will be a joke. Every rule will create a dozen loopholes to exploit that the slow moving professors never thought about. THEY can't control the markets. The big illusion is that government can cure the problems when in fact, THEY are the problem.
For the speculator, many new niches and many opportunity will arise. The government will be the ultimate slow mover. As they try to enter the market, as we have seen this last week, there are big waves kicked up. The least qualified populate government functions. Small and fast moving adaptors can thrive in such an environment. Seems that many big hedge funds are going down or weakening. The white shoe brokers are weak. The change will be good. It's just like evolution and climatic change. New species will arise. Many will perish unless they adapt. Even the data itself is reinventing itself with data over a year old being almost irrelevant. As Lack says, regulation will be a joke. Every rule will create a dozen loopholes to exploit that the slow moving professors never thought about. THEY can't control the markets. The big illusion is that government can cure the problems when in fact, THEY are the problem.
Friday, September 12, 2008
We're Still a Long Way from a Real Banking Crisis
So far this year, 11 U.S. banks have failed (FDIC data here), out of 8,451 FDIC-insured banks, matching the 11 bank failures in 2002. The last time more than 11 banks failed was 1994, when 15 banks failed on the tail end of the S&L crisis (see chart above). In total, almost 3,000 banks failed during the 15-year S&L crisis between 1980 and 1994.
The FDIC has currently identified 117 "problem banks" (through June 2008) with assets of $78 billion (data here), the highest level since 2002 when there were 136 "problem banks" following the 2001 recession (see chart below). This compares to the 1990-1992 period when there were more than 1,000 problem banks in each of those three years at the end of the S&L crisis, along with a recession in 1990-1991.
As a percent of total commercial bank assets (data here), the assets of troubled banks are currently at 0.71% (through second quarter), the highest level since 1995, but far below the 20-25 % levels in the early 1990s (see chart below).
We still have more than three months to go in the year, and there will certainly be more bank failures to come in 2008. There are also two more quarters of banking data to be reported, and there will probably be more banks added to the problem bank list. But at least back to the 1930s, there has never been a 5-year period of banking stability like 2003-2007 when only 10 banks failed, and the banking industry has probably never been in a better position to absorb a shock like the current subprime problems.
Problem banks are still a relatively small share (1.38%) of the 8,451 commercial banks, 98.62% of banks are not "problem banks," the assets of the problem banks represent less than 3/4 of 1% of total commercial bank assets, and therefore 99.29% of commercial bank assets are not in "problem banks."
The FDIC has currently identified 117 "problem banks" (through June 2008) with assets of $78 billion (data here), the highest level since 2002 when there were 136 "problem banks" following the 2001 recession (see chart below). This compares to the 1990-1992 period when there were more than 1,000 problem banks in each of those three years at the end of the S&L crisis, along with a recession in 1990-1991.
As a percent of total commercial bank assets (data here), the assets of troubled banks are currently at 0.71% (through second quarter), the highest level since 1995, but far below the 20-25 % levels in the early 1990s (see chart below).
We still have more than three months to go in the year, and there will certainly be more bank failures to come in 2008. There are also two more quarters of banking data to be reported, and there will probably be more banks added to the problem bank list. But at least back to the 1930s, there has never been a 5-year period of banking stability like 2003-2007 when only 10 banks failed, and the banking industry has probably never been in a better position to absorb a shock like the current subprime problems.
Problem banks are still a relatively small share (1.38%) of the 8,451 commercial banks, 98.62% of banks are not "problem banks," the assets of the problem banks represent less than 3/4 of 1% of total commercial bank assets, and therefore 99.29% of commercial bank assets are not in "problem banks."
Wednesday, September 10, 2008
Random Thoughts
The action on the first day of the month of September was highly unusual, and apparently at that time the employment number had leaked so the moves after that first day were much more likely to happen than before. After such bad starts the rest of the week has a standard deviation of 30 and only 50% chance of rise.
The 40 point S&P decline on Thursday was the fourth largest decline on a Thursday ever. By that time, the news was out, and the increase in unemployment was icing on the cake.
All this occured in conjunction with repeated highs in the fixed income prices around the world, and declines in the omniscient market in Israel below the round and Japan near three year lows of 12000 on the Nikkei.
To me, the key event was the raising of the Swedish discount rate during the night Thursday, causing an immediate 1% decline in all European equities. How come they weren't keyed in like the others to the forthcoming announcement?
The most hurtful piece of mass psychology was the naive notion about stocks having to go down because the P/E of 25 was the highest in 15 years, and that was bearish. Earnings are forecast next quarter to be the highest increase ever of 50% and you would think that people are taught to look at the future rather than the past for moves in markets.
There were many good economic numbers and bad economic numbers in the past week relative to expectations. What is it that caused the employment number to be the focus, other than the desire to paint the economy as weak before the election for obvious reasons of agrarianism? More important, why should a decline in employment at this stage be bearish for stock markets?
The one factor that made it seem so much like the end of the world was the the four day move down in S&P from the Thursday 8 28 close of 1298 to the Tuesday 9 04 close of 1236, a decline of 62 points was the second worst start of a week since the beginning of 2002, the only comparable being the four day move on 1 17 2008 before the French bank inside trading activity.
The 40 point S&P decline on Thursday was the fourth largest decline on a Thursday ever. By that time, the news was out, and the increase in unemployment was icing on the cake.
All this occured in conjunction with repeated highs in the fixed income prices around the world, and declines in the omniscient market in Israel below the round and Japan near three year lows of 12000 on the Nikkei.
To me, the key event was the raising of the Swedish discount rate during the night Thursday, causing an immediate 1% decline in all European equities. How come they weren't keyed in like the others to the forthcoming announcement?
The most hurtful piece of mass psychology was the naive notion about stocks having to go down because the P/E of 25 was the highest in 15 years, and that was bearish. Earnings are forecast next quarter to be the highest increase ever of 50% and you would think that people are taught to look at the future rather than the past for moves in markets.
There were many good economic numbers and bad economic numbers in the past week relative to expectations. What is it that caused the employment number to be the focus, other than the desire to paint the economy as weak before the election for obvious reasons of agrarianism? More important, why should a decline in employment at this stage be bearish for stock markets?
The one factor that made it seem so much like the end of the world was the the four day move down in S&P from the Thursday 8 28 close of 1298 to the Tuesday 9 04 close of 1236, a decline of 62 points was the second worst start of a week since the beginning of 2002, the only comparable being the four day move on 1 17 2008 before the French bank inside trading activity.
Back to US
Just came back from Australia, it's been a hell of a summer for me, traveling three countries and each with 20+ hours flights. Just as the market, which traveled further.
Thursday, August 28, 2008
The most amazing thing
The most amazing thing about markets to me is that no matter how many previous instances I have, I can never find days that are anywhere near the ones we are currently having. It is moving from x day highs to y day lows with impunity and alacrity and then hanging on the balance scale at the end of day when Zeus decides who will win.
I remember reading a book several years ago about Roger Bannister and his breaking of the four minute mile in 1954. At the time there were any number of physicians who predicted that the record was physically impossible to break; one predicted that Bannister's heart would explode to accomplish such a feat.
I was reminded of this in both watching (and hearing) that, once again, in a seemingly inexorable march of highs (and lows), world records were broken throughout the Olympics in Beijing.
It bears mentioning that the events themselves have changed greatly from year to year: not only in the rise of professional Olympians, undistracted from a training (indeed, a living) regimen by employment, formal education or social duties, but as well in the structure of the events themselves. Engineered swimsuits, deeper pools, vacated end lanes, and other such changes in swimming events alone have contributed to the aforementioned increase of extremes.
So too, I'd hypothesize, in the markets: that the year-over-year outdoing of previous records in extremes have as much, if not more…to do with the character, fragmentation and specialization of market venues; the "democratization" of access to various markets, bringing millions of additional opinions and hundreds of billions more dollars in; the rise of electronic, in particular algorithmic trading; better/faster processing speeds in technology; and the like, *ad infinitum*…than of any intrinsic quality of markets
I remember reading a book several years ago about Roger Bannister and his breaking of the four minute mile in 1954. At the time there were any number of physicians who predicted that the record was physically impossible to break; one predicted that Bannister's heart would explode to accomplish such a feat.
I was reminded of this in both watching (and hearing) that, once again, in a seemingly inexorable march of highs (and lows), world records were broken throughout the Olympics in Beijing.
It bears mentioning that the events themselves have changed greatly from year to year: not only in the rise of professional Olympians, undistracted from a training (indeed, a living) regimen by employment, formal education or social duties, but as well in the structure of the events themselves. Engineered swimsuits, deeper pools, vacated end lanes, and other such changes in swimming events alone have contributed to the aforementioned increase of extremes.
So too, I'd hypothesize, in the markets: that the year-over-year outdoing of previous records in extremes have as much, if not more…to do with the character, fragmentation and specialization of market venues; the "democratization" of access to various markets, bringing millions of additional opinions and hundreds of billions more dollars in; the rise of electronic, in particular algorithmic trading; better/faster processing speeds in technology; and the like, *ad infinitum*…than of any intrinsic quality of markets
Monday, August 18, 2008
Why Stocks May Not Go Down the Drain
BACK IN HIGH-SCHOOL MATH CLASS, ONE OF THE PROBLEMS I hated was this: A bathtub is filling at x gallons per minute, but water is draining at an (x-1) rate. How long before the 60-gallon tub is filled? The math geniuses -- most of whom probably run their own quant shops now -- figured it out relatively quickly, but I struggled. I'd always think, why not plug the drain?
Think of the market as the tank, substitute earnings growth for the water coming in and inflation for water going out, and investors are facing a similar challenge. The inflation rate has a crucial inverse affect on the market's price-to-earnings ratio: Higher inflation depresses P/E multiples, while lower inflation allows P/Es to expand, or the tub to fill, because companies lose less profit to inflated costs.
The latest figures suggest the worst, inflation up and earnings down. Thursday the July inflation estimate was released: up 0.8%, due to rising food, energy, airline and apparel prices, and up 5.6% from the level 12 months ago, for the highest jump in 17 years. Meanwhile, S&P 500 earnings were down about 22% in the second quarter, after falling 16% in the first, with most of that damage in the financials. With a global slowdown under way, the likelihood is that S&P 500 profits will show further quarterly drops, perhaps for the next six to 12 months. In other words, water is entering at a slowing rate, just as it's now draining at an accelerated pace.
But you don't need calculus to know that as bad as inflation is right now, it's likely to subside over the next 12 months, perhaps enough to mitigate the damage from earnings declines. Profits will drop, says Morgan Stanley European strategist Teun Draaisma, but history suggests that falling inflation could help expand P/E multiples enough to cushion the blow, keeping the overall market roughly where it is now. Morgan Stanley expects the U.S. inflation rate to slide to 2.8% by the end of 2009. Commodity prices, which have fallen significantly, will soon be lapping the outsized increases of 2007.
During past recessions in developed markets, he adds, at some point inflation peaked, even as profits still had a long way to fall. "In Europe, for example, in the 16 months beginning December 1974, corporate earnings fell some 40%, but the P/E went to 14 from six, and the market rose about 50%." Before you push the Buy button, Draaisma is looking for a flattish market, not a big rise, because the expected inflation drop won't be as large as those in previous recessions, nor is the current U.S. market P/E, about 14-15 times 2008 earnings estimates, as low as those in past contractions.
And there's a caveat. (There's always a caveat, isn't there?) The strategist sees a "garden variety" recession. A long and deep economic malaise could overwhelm the balm from lower inflation. Now, if we only had a stopper.
Think of the market as the tank, substitute earnings growth for the water coming in and inflation for water going out, and investors are facing a similar challenge. The inflation rate has a crucial inverse affect on the market's price-to-earnings ratio: Higher inflation depresses P/E multiples, while lower inflation allows P/Es to expand, or the tub to fill, because companies lose less profit to inflated costs.
The latest figures suggest the worst, inflation up and earnings down. Thursday the July inflation estimate was released: up 0.8%, due to rising food, energy, airline and apparel prices, and up 5.6% from the level 12 months ago, for the highest jump in 17 years. Meanwhile, S&P 500 earnings were down about 22% in the second quarter, after falling 16% in the first, with most of that damage in the financials. With a global slowdown under way, the likelihood is that S&P 500 profits will show further quarterly drops, perhaps for the next six to 12 months. In other words, water is entering at a slowing rate, just as it's now draining at an accelerated pace.
But you don't need calculus to know that as bad as inflation is right now, it's likely to subside over the next 12 months, perhaps enough to mitigate the damage from earnings declines. Profits will drop, says Morgan Stanley European strategist Teun Draaisma, but history suggests that falling inflation could help expand P/E multiples enough to cushion the blow, keeping the overall market roughly where it is now. Morgan Stanley expects the U.S. inflation rate to slide to 2.8% by the end of 2009. Commodity prices, which have fallen significantly, will soon be lapping the outsized increases of 2007.
During past recessions in developed markets, he adds, at some point inflation peaked, even as profits still had a long way to fall. "In Europe, for example, in the 16 months beginning December 1974, corporate earnings fell some 40%, but the P/E went to 14 from six, and the market rose about 50%." Before you push the Buy button, Draaisma is looking for a flattish market, not a big rise, because the expected inflation drop won't be as large as those in previous recessions, nor is the current U.S. market P/E, about 14-15 times 2008 earnings estimates, as low as those in past contractions.
And there's a caveat. (There's always a caveat, isn't there?) The strategist sees a "garden variety" recession. A long and deep economic malaise could overwhelm the balm from lower inflation. Now, if we only had a stopper.
Wednesday, August 6, 2008
The End of the Era of US Dominance?
You can read a lot lately about the end of the US dominance era. Many dare to compare the Roman empire with the United States. Examples can be demographics issues with "barbarians" entering the empire as workforce (as opposed to invaders) while the average "citizens" age increases, high military expenses to maintain presence along the borders, big trade deficit as rich consumers help grow poorer neighbors that produce at lower costs. Environment, food, climate change, and energy are additional problems, which are not exclusively "American", but require a global response. Let's leave aside the parallels between Romans and Americans. There are multiple futures ahead with profound implications from the U.S. perspective. The main drivers are related to:
- energy: peak oil and dependence from foreign sources;
- technology: what happens if the technology gap narrows in favor of competitors?;
- demography: older population and immigration issues;
- climate change;
- global governance and geopolitics: failing states and emergence of areas of regional/global power (Asia/resurgence of Russia).
There could be many other drivers, but, in my opinion, the analysis of the implications of the different future scenarios should start from the present situation.
Twenty years after the end of the cold war the US remains the only global power, however, I think that being global in the years past has shown itself to be too expensive for the benefits it gives. The efforts required to maintain a constant (or even increasing) high level of global presence are too high. The main point is that marginal costs are higher than marginal benefits. In summary, if this trend continues, the country could enter a long decline era, where vital resources are wasted to "guard the outposts of the empire" instead of being used to sustain the country's capitalistic and entrepreneurial spirit. Maybe a global strategy should be set aside in favor of a reduced and more focused intervention in specific critical areas and issues. At the same time, concerns about US "strategic competitors", should not be excessive. No country, from China to Russia and each for different reasons, can cultivate the ambition to become a global player for decades to come. The US should manage the comparative advantage in technology, military, innovation potential, financial markets, social development, property rights, education, and so forth, making a better use of its huge resources. The current trend of deficits and debt is not going in this direction. Many consider this trend acceptable and manageable. Actually, my personal opinion is that a continuously weaker currency, higher inflation, increasing private and public debt, a fragile credit system display that the current strategy (with the related cost and budget implications) cannot be sustained much longer. If we look at the stock market, which represents the economy, in the past ten years it has not grown that much. And, if we take into account exchange rates, the situation looks even less satisfactory. The wave of innovation (and source of huge profits) brought by the advent of the information age in the nineties was initiated and "owned" by US technology and US companies. Microsoft, Intel, Oracle, Cisco, Yahoo! and so forth are some examples. The last wave, still ongoing, but limited in its effects, is now represented by Google and Apple. This sector is getting mature and growth appears to be slower with time. In general, the stock market performance reflects a mature economy where growth can be sustained only at the cost of higher inflation. The US needs badly a new wave of innovation. Where is the next wave coming from? Will US companies once again be protagonists? This is what is really crucial in the next decade. Energy dependence is one important aspect, also from the national security perspective, to take into account in this scenario. Is alternative energy going to drive the new technological developments and the needed growth? Biotech? Nanotechnologies? Very difficult to say. Very important, however, is that resources be allocated properly to maintain the intellectual and cultural leadership in the various fields of human and economic interest and not dispersed to support global strategic efforts, which could reveal themselves as unsustainable in the long term.
- energy: peak oil and dependence from foreign sources;
- technology: what happens if the technology gap narrows in favor of competitors?;
- demography: older population and immigration issues;
- climate change;
- global governance and geopolitics: failing states and emergence of areas of regional/global power (Asia/resurgence of Russia).
There could be many other drivers, but, in my opinion, the analysis of the implications of the different future scenarios should start from the present situation.
Twenty years after the end of the cold war the US remains the only global power, however, I think that being global in the years past has shown itself to be too expensive for the benefits it gives. The efforts required to maintain a constant (or even increasing) high level of global presence are too high. The main point is that marginal costs are higher than marginal benefits. In summary, if this trend continues, the country could enter a long decline era, where vital resources are wasted to "guard the outposts of the empire" instead of being used to sustain the country's capitalistic and entrepreneurial spirit. Maybe a global strategy should be set aside in favor of a reduced and more focused intervention in specific critical areas and issues. At the same time, concerns about US "strategic competitors", should not be excessive. No country, from China to Russia and each for different reasons, can cultivate the ambition to become a global player for decades to come. The US should manage the comparative advantage in technology, military, innovation potential, financial markets, social development, property rights, education, and so forth, making a better use of its huge resources. The current trend of deficits and debt is not going in this direction. Many consider this trend acceptable and manageable. Actually, my personal opinion is that a continuously weaker currency, higher inflation, increasing private and public debt, a fragile credit system display that the current strategy (with the related cost and budget implications) cannot be sustained much longer. If we look at the stock market, which represents the economy, in the past ten years it has not grown that much. And, if we take into account exchange rates, the situation looks even less satisfactory. The wave of innovation (and source of huge profits) brought by the advent of the information age in the nineties was initiated and "owned" by US technology and US companies. Microsoft, Intel, Oracle, Cisco, Yahoo! and so forth are some examples. The last wave, still ongoing, but limited in its effects, is now represented by Google and Apple. This sector is getting mature and growth appears to be slower with time. In general, the stock market performance reflects a mature economy where growth can be sustained only at the cost of higher inflation. The US needs badly a new wave of innovation. Where is the next wave coming from? Will US companies once again be protagonists? This is what is really crucial in the next decade. Energy dependence is one important aspect, also from the national security perspective, to take into account in this scenario. Is alternative energy going to drive the new technological developments and the needed growth? Biotech? Nanotechnologies? Very difficult to say. Very important, however, is that resources be allocated properly to maintain the intellectual and cultural leadership in the various fields of human and economic interest and not dispersed to support global strategic efforts, which could reveal themselves as unsustainable in the long term.
Friday, August 1, 2008
Ten Basic Laws
1. The trend is your friend
2. Don't confuse brains with a bull market
3. 50% of the movement in a stock is due to the overall market, 30% to the industry group, and 20% of the fundamentals of the company.
4. 80% of the research budget of a Wall Street brokerage firm is devoted to fundamental analysis.
5. Sellside analysts make more money than buyside analysts.
6. The problem in trendfollowing is determining when trends start and when they end.
7. The market can stay irrational far longer than you can stay solvent.
8. The more available information is, the less useful it is.
9. Figures lie and liars figure.
10. When you sit down to a poker game, look around the table to find the pigeons. If you can't find any, you're the pigeon.
2. Don't confuse brains with a bull market
3. 50% of the movement in a stock is due to the overall market, 30% to the industry group, and 20% of the fundamentals of the company.
4. 80% of the research budget of a Wall Street brokerage firm is devoted to fundamental analysis.
5. Sellside analysts make more money than buyside analysts.
6. The problem in trendfollowing is determining when trends start and when they end.
7. The market can stay irrational far longer than you can stay solvent.
8. The more available information is, the less useful it is.
9. Figures lie and liars figure.
10. When you sit down to a poker game, look around the table to find the pigeons. If you can't find any, you're the pigeon.
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