Storm Watch Update from Jim Puplava
June 28, 2002
Musical Chairs
by Jim Puplava
<<In order for this imbalance to be corrected, supplies will have to be increased. The only way that is going to be done is through higher prices. No company is going to stay in business or invest to expand production without the incentive of earning a profit. This means higher prices. We will get higher prices through the mechanism of the markets or we will get them through scarcity if governments try to intervene to inhibit rising prices through price controls. Either way, prices are going higher.>>
Today in North and South America, we have currency depreciation, and in some countries, outright devaluation. Global equity indexes are falling in all parts of the world, whether it’s the Americas, Europe or Asia. Most world stock markets are down high single-digits or in some cases, double-digits this year. Credit spreads between government debt and corporate debt is widening. Credit fears are heightened. Money market yields are next to nothing. Here in the U.S. the seven-day simple yield for taxable funds fell to 1.31 percent. The thirty-day simple yield remains at 1.32 percent.
Daily headlines are filled with stories of fraud, criminal probes, bankruptcies, and CEO resignations. For investors, it has become a game of musical chairs as they try to find a safe spot to land. Instead of years of double-digit returns, we now have consecutive years of double-digit losses. The financial markets are faced with a crisis in confidence as investors decide how much longer they can stand the pain. Some have already reached the endurance limit and are heading for the exit gates. They have seen their portfolios go down for three years in a row. Yet, the majority of investors are still holding on, hoping that the markets will bounce back. That is what markets have always done in the past -- at least, that is what they have been told. "Buy and hold for the long-term" has been the bull market mantra. All that is needed is a better asset allocation model. The easy days of making money are over -- that much has been acknowledged. Today's question is, "Where can I make money in this market and safely ride out the storm?"
Large caps, small caps, international equity funds, bonds, or even real estate are all under consideration. Investors are still thinking of rates of return instead of preservation of capital. Apparently, the investment implications of a bear market haven’t gotten through to investors. In bear markets, stocks go down -- some faster than others. Like in the game of musical chairs, both advisors and investors switch from one investment to another, hoping to be parked in the right investment when the music stops. The message seems to be, "Hang in there. The markets always come back."
The Paper Chase
Will it be equity markets?
Grasping at hope, investors are still playing the game. Instead of large caps, money is flowing into small caps because they have held up better over the last few years. However, there are fewer spots to land on in this game of chasing paper. Very few segments of the stock market are holding up this year. Just when you think you have found a safe spot, a major scandal erupts that reverberates throughout the financial system. The news of WorldCom on Wednesday momentarily widened credit spreads by almost 300 basis points. The stock markets in the U.S. and globally plunged to new depths. It looked like a meltdown was in the process. On Thursday, CNBC did a story that Morgan Stanley, Goldman Sachs and Merrill Lynch had executed huge buy programs in the futures market for 'a large undisclosed account.' One can only speculate as to identity of the large, unnamed buyer. In a flash, the markets turned around and avoided a collapse.
Scandals like WorldCom are becoming more frequent these days and they are taking their toll on investor psyche. The scandals have much broader implications that go beyond a domestic constituency. Globally, confidence in the U.S. is evaporating. It isn’t just the domestic investor who is thinking of withdrawal. It is the foreign investor that we have to worry about. Already, money flows into the U.S. are starting to slow down and in some cases the money is exiting the U.S. markets.
Description
Value % Ytd % YtdCur
(USD)
North/Latin America
DOW JONES INDUS. AVG 9269.92 -7.50 -7.50
S&P 500 INDEX 990.64 -13.71 -13.71
NASDAQ COMPOSITE INDEX 1459.20 -25.18 -25.18
S&P/TSX COMPOSITE INDEX 7073.81 -7.99 -3.09
MEXICO BOLSA INDEX 6400.89 +.45 -7.78
BRAZIL BOVESPA STOCK IDX 11013.32 -18.89 -33.80
Europe/Africa
BLOOMBERG EUROPEAN 500 177.79 -17.57 -8.37
FTSE 100 INDEX 4540.60 -12.97 -8.61
CAC 40 INDEX 3742.78 -19.07 -10.04
DAX INDEX 4259.43 -17.45 -8.25
IBEX 35 INDEX 6695.80 -20.27 -11.37
MILAN MIB30 INDEX 27016.00 -16.26 -6.92
AMSTERDAM EXCHANGES INDX 419.06 -17.31 -8.09
OMX (STOCKHOLM) INDEX 594.96 -29.71 -19.80
SWISS MARKET INDEX 5717.90 -10.91 -.69
Asia/Pacific
NIKKEI 225 INDEX 10512.86 -.28 +9.93
HANG SENG INDEX 10665.25 -6.42 -6.44
S&P/ASX 200 INDEX 3220.90 -5.88 +4.33
Source: Bloomberg, June 27, 2002
As this Bloomberg table shows, market returns have been horrific this year, but less so when denominated in foreign currencies. (Note 3rd column.) This reflects the U.S. dollar's depreciation against major currencies around the globe. Had you invested in the Japanese markets you would have lost money this year. But overall, you would have a positive return thanks to the appreciation of the yen against the dollar.
Many investors have sought refuge in foreign denominated paper assets such as stocks and bonds. Foreign denominated bonds in the Euro and the yen have produced positive returns for investors this year. For the third year in a row, bonds in general are outperforming stocks as shown in the graph below. As equity markets have fallen and as central banks have lowered interest rates to thwart a recession, bonds have appreciated in value. Bonds have been one of the few safe havens in the storm so far. However, with interest rates at historical lows, and with central banks flooding the financial system with liquidity, the question of paper devaluation comes into play. This is reflected in the dollar's decline this year. Confidence in the U.S. economic and financial system is ebbing. Looking further out this year, the question remains, "How will the U.S. financial markets and the dollar react if the U.S. economic recovery is aborted later on this year? In my opinion, much of the optimism of a future recovery is misplaced when basing its confidence on a debt-burdened consumer.
The problem investors at home and abroad have with the U.S. economy and the financial system is what to believe. As more scandals break out, the myth of the new paradigm is evaporating. Nobody has much faith in the financial numbers anymore. This disbelief is becoming more pervasive and it doesn’t end with U.S. companies. It applies to the U.S. government's own numbers as well.
In a recent article by Morgan Stanley’s Stephen Roach titled House of Mirrors, the economist says, "Washington statisticians seem poised to join the restatement sweepstakes with a stunning rewrite of the recent performance of the U.S. economy”. 1 According to Roach, the report to be released July 31, will contain benchmark revisions of major economic statistics. Based on more complete data, a major revision of GDP growth during the 1999-2001 periods will be included. He further states preliminary revisions will include major downward adjustments in capital spending, foreign trade in services, and personal income. The downward revisions will put to rest the myth of the Great American Boom.
As he puts it, "We have a saying in America, 'What goes around, comes around.' Sadly, the numbers we were told to trust have simply turned out to be wrong — wrong for companies, wrong for the economy at large, and wrong in the eyes of the financial markets. I guess the words of Benjamin Disraeli will always haunt me, 'There are three kinds of lies: lies, damned lies, and statistics.'" 2
It is the specter of these revisions, and the possibility of an aborted recovery later this fall, that hangs like the Sword of Damocles over the financial markets. Investors have held on for close to three years on hopes and promises that things are going to get better -- better for the economy and better for the stock market.
What happens if the recovery is aborted? What happens if company earnings don’t improve as predicted? Are investors going to wait another year in the hopes that maybe the fourth time the forecasters will finally get it right? The markets could be in for some very shocking economic and financial disappointments later on this year.
What is absent from most discussion is that booms are always followed by busts. Plain and simple: bear markets always follow bull markets and they can last for a very long time. As these charts clearly show, the bear markets of the late 20’s following the crash, did not end until 1953.
The bear market that began in the mid 60’s did not end until 1982. At the risk of sounding repetitive, periods of above-average returns are always followed by periods of below-average returns. These periods of below-average returns include years of negative returns as asset classes revert to the mean.
Poor Value in Valuations
What is even more important going forward is that dividend yields, which have played an important part of equity returns, are dismal as shown in this chart. As of today, the dividend yield is 2.03 percent for the Dow, 1.60 percent for the S&P 500, and only .08 percent for the Nasdaq. In their book Triumph of the Optimists the authors point out that dividends have been a critical component of long-run gains in making money in the stock markets. “Over the course of the last 101 years, a portfolio of U.S. equities with dividends reinvested would have grown to 85 times the value it would have attained if the dividends had been squandered.” 3 The authors found that dividend growth played an important role in key valuation models and in financial research. By the end of 2001, dividend yields were close to a 101-year low.
If investors are looking to achieve high returns in equities, the fact that dividend yields are this low reduces that possibility. As various asset classes are examined, it is hard to find values, bargains, or even good dividend yields anywhere. The P/E ratios on the major averages translate to an earnings yield that ranges from 2-4 percent. With P/E multiples still high and dividends at century lows, it is hard to make a strong case for paper assets. Even if the economy does recover and remains in a recovery mode, there are no compelling arguments to be made for owning traditional equities. A point that cannot be stressed enough times is equity valuations are "stretched." No matter which way you look at the markets -- P/E, dividend yield, price to book, price to sales, etc. -- the market is simply overpriced. This is especially true given their future growth prospects.
Where Does The Investor Find Value?
This brings me back to the game of musical chairs. What is safe? Where can investors find value? Where will the best returns be realized this year and the years ahead? Once again, I return to real assets. With governments depreciating their currencies, some faster than others, and with the myriad financial and political crises around the globe, the one asset class that stands out is “things” -- hard goods otherwise known as commodities.
Will it be raw materials?
As Jim Rogers has written in Why Raw Materials?, there have been bull markets in raw materials every 20-30 years. These bull markets begin when demand outstrips supply. Lower prices discourage investment and production of new resources. To quote Rogers, “Virtually no one has built an offshore rig, or opened a lead mine, or developed a sugar plantation during this period. Quite the opposite -- productive equipment has deteriorated, been cannibalized, or scrapped while other capacity has closed." 4
Will it be oil and energy?
Despite shrinking supply, demand has continued to increase each year because of population growth and developing economies around the globe. Supply deficits have been made up from above-ground stockpiles. In the area of energy, we are getting the majority of our oil from wells discovered 40-50 years ago. Demand for oil has grown in 49 of the past 56 post-WWII years. 5 Almost all of that demand growth is occurring outside OECD countries. In the case of natural gas, the picture looks even brighter. Demand is expected to increase by 35 percent because of population growth and a major expansion in gas-fired power plants in the U.S.. And despite a recent drilling boom, there has been no major significant increase in the supply of natural gas. The failure of a major drilling boom to raise supply raises serious concerns over the next decade given the demand for increased electricity use.
Will it be precious metals?
In the case of hard metals such as silver and gold, the prospects look equally compelling. Mine production for silver and gold will start to decline in the next few years as the industry has failed to add to reserves. Low prices, consolidation, and mine closures will make it harder for gold and silver producers to keep up production. Today the majors are swallowing the mid-tiered companies and the juniors to replace their reserves. None of these acquisitions is doing anything to increase supply on a global basis. What makes this story more extraordinary is that monetary demand for metals hasn’t even entered into the equation outside of Japan where it is up over 100 percent from the previous year. Central bank sales, precious metals leasing, producer hedging, and investor dishoarding have covered most of these supply deficits. Prices have been declining because of inventory liquidation whether it is silver, gold, or energy resources.
In order for this imbalance to be corrected, supplies will have to be increased. The only way that is going to be done is through higher prices. No company is going to stay in business or invest to expand production without the incentive of earning a profit. This means higher prices. We will get higher prices through the mechanism of the markets or we will get them through scarcity if governments try to intervene to inhibit rising prices through price controls. Either way, prices are going higher.
Four Risks to The U.S. Dollar
I suspect as economies start to falter, central bank policies will try to fight the forces of deflation with a mammoth effort to reinflate their respective economies as is now occurring in the U.S. This should become apparent if major countries intervene in the currency markets as Japan is now doing. In fact, it would not be surprising to see Japan and Europe resort to monetary easing in a concerted effort to limit the dollar's decline. With their economies heavily dependent on exports, monetary accommodation is the more likely path.
This still leaves the dollar at risk for four primary reasons. America is running a huge trade deficit that is now approaching close to 5 percent of GDP. A second reason is that Fed monetary policy is extremely loose as shown by the growth in M-3. As the chart indicates, the supply of money in the system has increased by close to $1.5 trillion in the last two years.
A third reason is that foreigners own a large portion of our bond and equity markets. As the Bloomberg table above indicates, declines in the equity market, combined with a 10 percent decline in the dollar since March, have saddled foreign investors with another year of double-digit declines. If this trend continues, it can be expected that some of this money will exit our markets and the dollar.
The fourth reason is one of security. Unlike the past, the attacks on 9-11 show that the U.S. is no longer immune to the threats that have harmed other nations and economies. 9-11 exposed America’s vulnerabilities. The War on Terror is just in its formative stages. The U.S. vows to take preemptive steps against future attacks. A move against Iraq is widely anticipated this fall or next winter. I believe this explains the massive build up U.S. military assets in the Middle East. America’s vulnerability to attack and a major escalation in the War on Terror will keep foreign investors on edge with their U.S. investments.
Possible Higher Interest Rates Increase Vulnerability
With the prospects of an escalating war on the horizon, and the constant battering of the financial markets, monetary policy will be kept on suspension. Given the current state of fragility in the U.S. financial system, a spike in interest rates would cause the whole financial system to implode. Higher interest rates would put an end to the refinancing of mortgages and the housing boom, one of the last remaining pillars of strength within the economy. Higher interest rates would also make equities much more vulnerable.
Greenspan’s options are limited. Interest rates are already at record lows. With the U.S. equity markets becoming more important to America’s financial health, the Fed will do everything possible to keep the markets liquid and afloat. This also means keeping investors corralled in paper assets by limiting their options for return. With money market returns as low as 1.3 percent, and bank CD’s offering no more than 2-3 percent, investors will be hard pressed to find returns of 4-5 percent, not to mention losses which are the more likely outcome.
The Bull & Bear of Today's Market
The game of musical chairs will continue, but there are going to be fewer chairs standing. It hasn’t quite dawned on investors that the bull market in equities is over. The equity cult still lives on. Despite the bashing that investors have taken over these last few years, the majority of Americans have kept their assets invested in the stock market. However, many more mutual funds are now starting to report redemptions. Still others report that sales are slowing. While still invested in equities, investors are starting to get worried. A Wall Street Journal article reported Thursday on how investors' resolve is being tested. In the words of one investor, a 58-year-old consultant approaching retirement whose portfolio has fallen 25 percent this year, “It just feels like the market is going to keep on plummeting.” 6 The consultant had resolved that she has had enough in losses and has made an appointment to discuss options with an advisor. “We’re approaching retirement and we need to protect our money,” she says. 7 How many more investors are thinking the same thing?
Investors seem to be oblivious to the bear market -- now in its third year -- and ignorant of the new bull market in “things” -- which has only just begun. As these charts clearly show, there is an obvious gulf between the two.
When the music stops for the economy and the financial markets, it looks like "things" will be the last chair standing. The bear market in things is drawing to conclusion as decades of supply and demand imbalances will have to be addressed. Just as it will take higher prices to ameliorate supply deficiencies, it will also take higher prices to convince investors that this new bull market is for real.
Trends and changes in the financial markets are often subtle and go unnoticed. Sometimes it takes time for the new trend to be absorbed and for market opinion to shift in the direction of the new trend. There are also the vested interests in the old trend that reside in Washington and on Wall Street. Washington is in the business of printing paper; while Wall Street is in the business of selling it.
As I have written in the conclusion of my Storm Series, one man’s winter is another man’s summer. We have entered the winter months for financial assets; while summer is just beginning in tangible assets, especially in gold and silver. The greatest returns will be realized by those who buy what is cheap now before this new trend is embraced by the herd. The time to look for a chair is now -- before the music stops. ~ JP
© 2002 James J. Puplava
ENDNOTES
1 Roach, Stephen, "House of Mirrors," Stephen Roach Weekly Commentary, Morgan Stanley, June 27, 2002, p. 1.
2 Ibid., p. 2.
3 Dimson, Elroy, et. al, Triumph of the Optimists, Princeton University, Princeton, 2002, p. 161.
4 Rogers, Jim, Why Raw Materials?, Financial Sense Online, June 25, 2002.
5. Simmons & Co. International, The Global Energy Scene, May 21, 2002.
6 Lucchetti, Aaron & Damato, Karen, "Small Investors' Resolve is Tested -- Again," Wall Street Journal, June 27, 2002, C1.
7 Ibid.
financialsense.com |
