Richard Russell commentary
January 26, 2004 -- Today I'm going to present a discussion between two characters named A and B. Who are these guys? They're two guys who live between my ears. Somehow, these two clowns got into my skull over the weekend.
A -- What are the fundamentals, the very basic fundamentals, of the investment world today?
B -- Here they are, and I don't think you're going to love them. The world is overproducing. Not only is it overproducing, but it's overproducing at viciously competitive prices. Over 2 billion low-salaried workers have entered our new global world, and I'm talking about the people of China, India, much of Asia and even eastern Europe.
The entrance of all these low-salaried workers has turned the world economic situation on its head and upside down. But never fear -- the US consumer has been the savior of the situation -- at least so far. The US consumer has been buying and buying and, in the process, building up debt.
However, it's not as easy as simply US consumers buying, and the situation is far from being solved. You see, world overproduction has brought on powerful deflationary forces. Pricing power, as we knew it in the '60s through the early '90s, is over, due to this new world competition. On top of that, the Internet has created a "buyer's revolution" -- it has allowed consumers to pick the best and lowest-priced item in any category.
A -- So how come we're not in a recession or even a depression?
B -- Following the collapse of the great stock market bubble (after 2000), a bear market took over and the stock market headed down. In 2002, the Greenspan Fed, aghast at having aided stocks in allowing stocks to reach bubble proportions, sought to fight the vicious new bear market "tooth and nail." The Fed flooded the system with liquidity while driving short rates down to 45-year lows. The name of the new game -- re-inflation.
A -- Great, so that ended the bear market?
B -- Not exactly. The Fed has simply held off or put off the bear market. But the deflationary forces remain. In the great battle to forestall deflation, the Fed has promised the markets that it would hold short rates at 1%. To do this, the Fed had to continue flooding the system with liquidity. This resulted in asset inflation, meaning rising stock prices and surging real estate prices. Which is exactly what the Fed wants.
But a 1% rate is an inflationary rate, since it takes a massive creation of dollars to keep rates that low. The Fed has decided that it would not control money, it would control rates.
A -- So what's the problem?
B -- One huge problem is that the poor US saver has been put on the spot. At 1% he can't generate any income from his time-honored "safe" areas -- CDs, money market funds and T-bills. The Fed has turned a great mass of Americans into being either speculators or borrowers. People who depended on "safe income" are now forced to go into debt in order to meet their normal living expenses -- or they are forced to speculate in the hope of bringing in the needed income.
In fact, all America has gone on a debt-creating binge. Debt is now three times the US Gross Domestic Product -- which is actually more than twice its historical norm.
A -- What does that mean?
B -- It means that, above all, the Fed cannot allow deflation. Deflation is the bitter enemy of debt. Deflation causes debt to loom larger making it more difficult to pay off. Rising interest rates plus deflation spell disaster. Therefore, count on it -- the Fed will do anything and everything to ward off the current deep-lying forces of world overproduction and debt-creation.
A -- So what am I, as a consumer, investor, saver, to do?
B -- The whole situation puts us over a barrel -- better known as "against the wall." I hate to say it, but as investors, it places us in what I term "survival mode." I know that the great majority of Americans are not traders. They do best if they assume a certain position in the markets, and pretty much stay with that position. But in today's markets, which are so difficult and so volatile, that's hard to do.
There is no position today that is without high risk. Even in the Great Depression of the '30s, if you stayed in cash or top-quality bonds you were fairly safe, and you received income. At the same time, some stocks such as AT&T and Woolworth and Sears remained safe. And those stocks during the Depression offered high yields. Not so with stocks today. Today, with the exception of certain utilities, stocks provide little or no yield. Today, as I said, we're forced into "survival mode," a situation where even our own currency is at risk.
But there's an alternative in every situation, and today in a world of competitive currency devaluations, we have gold. Gold is real money that can't be destroyed or go bankrupt. Gold doesn't depend on any nation to confirm its value. The problem with gold is that although it's "safe," it pays no interest.
A -- Then why do I need gold at all?
B- There's no way of proving that you do. Gold is simply the ultimate insurance against a collapse of the dollar an unraveling of the paper money system or some other disaster, although, of course, the odds are always against a catastrophe.
However, I believe gold is in a primary bull market. And true primary bull markets always end with something akin to "insanity on the upside." So speaking personally, I want to be in gold because I want to be invested in a primary bull market. My real problem is how much gold to own, and should I be in gold or gold shares?
The real truth is that there's no perfect answer to the current investment dilemma. I think you should take a certain percentage of your assets and put those assets maybe two-thirds in gold bullion and one-third into gold shares. The bullion coins are as safe as you can get, but the leverage is definitely in the stocks.
A -- How much of your assets would you put into the gold area?
B -- That all depends on your financial situation and your disposition. Let me put it this way, and this is a funny way of putting it -- I would put only as much in percentages as you are willing to ride on the downside without freaking out.
A -- Yeah, that is a funny way of putting it. How about trading the gold shares (OK, I won't trade the coins)?
B -- The odds on trading the shares or even using stops is that you'll almost always end up OUT of the shares. One way or the other, the market will take you out, and it will leave you out just when you want to be back in. Therefore, I suggest that you take a position that you can live with -- even if that position is fated to correct up to 50%, and sit with that position. The average investor simply cannot trade a bull market successfully. Traders invariably end up OUT when they should be IN.
A -- I couldn't take a 50% decline in my gold shares. I'd sell out before that happened.
B -- Listen, there's nothing more volatile than a gold bull market. "If you can't take the ride, then you're better off stepping aside." Or you can look at it this way -- take a position in gold shares of say 15% of your assets. Then if the shares drop 50%, you're only down 7-8% of your total assets. You can live with that.
And remember this -- the Fed has promised to hold short rates at 1%. As long as short rates are at 1%, that is a very strong force for re-inflation. It allows the system to further liquefy and inflate. That 1% short rate alone is an overall pressure for higher gold prices. But, of course, gold will correct. Every item that trades will correct.
A -- But I note that over the last few months, the broad money supply, M-3, has declined by almost $200 billion. That's hardly inflationary -- in fact, some people think it's deflationary.
B -- True, but ta ta -- the Fed to the rescue. The last two reports show M-3 up $30 billion and then up a huge $37 billion. The Fed has resumed pumping -- big time. As I said, the Fed will do anything and everything to ward off even a hint of deflation.
A -- What about the dollar? Suppose the dollar collapses? How would that affect me?
B -- We live in dollars. Everything we buy is in dollars. So a dollar collapse would "kill" foreign holders of US assets, but it wouldn't affect us nearly as badly. You would still buy your food and you would still pay your taxes with dollars. However, a dollar collapse would send interest rates spiraling higher, and that would most definitely affect us. Remember, rising rates are deflationary.
Higher rates and deflationary forces would be "murder" on a debt-laden US. I don't even want to think of what would happen if rates were to run out control on the upside in the face of the US debt situation today.
A -- I need income, and I don't know how to get it without taking on big risks.
B -- Yes, that's what Greenspan's short-rate policy has done to all savers and everybody who needs income. At 1% the banks can borrow money, and then turn around and buy bonds. The banks profit on the difference, so a 1% short rate allows the banks to liquefy. Note that the Fed keeps telling us that they will hold that 1% rate for a "considerable" length of time. What they're really doing is telling the banks that they remain safe playing the yield curve. Also, note that the daily new high list of stocks is led by the banks and the financials. These are the guys who are prospering in that 1% rate. And of course, the low rates have created the housing bubble and the refinancing bubble. And that's what the Fed has wanted -- rising assets, meaning rising stock and home prices.
A -- But what happens when rates head up again?
B -- The Fed thinks that by flooding the system with liquidity and holding rates down, somehow employment will pick up again, and somehow prosperity will return. And, of course, Greenspan hopes to be retired and out of office if or when the trouble hits.
A -- Should I be buying bonds or munis or foreign bond funds or foreign bonds? And should I protect myself from a weak dollar?
B -- I've been around for a long time, and this is the first time I can say that I don't see any island of real safety. As matters stand today, any item I'm in is at risk. Even during the Great Depression, you could be in dollars and be safe. Not so today -- due to the twin deficits (trade and budget) we're at risk even if we're 100% in dollars. Furthermore, since investing in dollars via money market funds or T-bills provides almost no yield, we have the ironic problem of being unsafe holding dollars plus we get no income from dollars.
Thus, if we must have income we're forced to buy utility stocks or bonds or preferreds. If interest rates ultimately rise, which they will, all three of these will be under pressure. Thus, there's no real safety buying utilities or bonds or preferreds when prevailing short rates are at 45-year lows, as they are now. As things stand, rates have nowhere to go but up.
A -- So the situation is that I want to be "safe," but today everything I do is a speculation?
B -- That's correct. You see, the background of the whole situation today is that we're living in a world where a primary bear market is being masked, covered over by a Fed that will not allow the economy to correct. The Fed has done this by flooding the system and manipulating rates. The result is that it's put serious investors in a terrific bind. The bind is that there's no way to be safe even if you don't need income. And ironically, if you do need income you place yourself even more at risk.
A -- How about going way out in Treasuries -- the long T-bond pays almost 5% and that's free of state taxes?
B -- Well, you can do that, but you may have to go 20 or 25 years out to get near a 4.95% yield. Assuming all goes well, you'll get your money back when the bond matures. But in 20 or 25 years, the dollars you receive from your maturing bond will have lost half or more of their purchasing power. It's a ticket to bankruptcy from that standpoint.
A -- Well, then what do we do? I'm totally lost.
B -- There's no perfect strategy at this point. I think you have to diversify. In that way, you're probably be in position to lose the least. If you're in cash, gold and gold shares, maybe some silver and silver shares, say some German notes denominated in euros, some Treasury notes going out maybe eight or 10 years, maybe some Diamond ETFs, all of those, you'll be doing about as well as can be expected in the months ahead.
A -- So you can't come up with any brilliant answers regarding how to handle my money?
B -- Hey, Bill Gross is talking about Dow 5000 somewhere ahead. Warren Buffett can't find any stocks he likes. Templeton is very bearish and talking about real estate falling 90%. Soros doesn't want his money in the US at all. The smartest guys in the world are scratching their heads and saying that they don't have any brilliant answers. That tells you pretty clearly (or should I call it -- cloudy) where we are today.
Actually, your best bet is owning your own business or having a good job that continues to bring in good pay. But even there, we have problems. The shipping of American's manufacturing facilities to China (and now its services to India) has been eliminating the good jobs in the US. The middle class is being systematically destroyed.
The hard fact is that the gravy train in the US is coming to the end of the tracks. I keep telling myself that the numbers are no good. When you can produce overseas at 70% less then you can produce here, we're going to feel some pain. The global world is a new world, but most people don't get it yet. The poor people of China and India and Asia have taken the pain for years, for decades, while America has enjoyed that phenomenal advantage of living over its head, and paying its bills with our reserve paper currency.
That incredible joy-ride is now being endangered. Somehow it's got to bring us pain. Up to now, the pain has been confined to unemployment, the loss of good jobs in the US. The bear market has been covered up and covered over by the Fed.
The US's magic ability to run huge deficits and pay those deficits off with money that it creates has allowed for a high standard of living in this nation. But what happens if, over time, the rest of the world resists taking in our paper in return for its merchandise and services? That's the dilemma that everyone in this country faces.
Diversify and try to save in terms of real money. If there's an ultimate savior at all, I don't think it will be the Fed -- I think it will be gold.
A -- Going back to diversification, you suggested positions in Diamonds, which are ETFs, each worth one-tenth of the value of the Dow. Do we continue holding the Diamonds?
B -- Yes, I suggested holding the Diamonds until we receive some sort of a "sell signal" or breakdown in the price structure of the Dow. My "Sell signal" will be a downside violation of Dow 10427. And to put it succinctly, that hasn't happened yet.
Notes & Quotes -- This from Paul Macrae Montgomery of Legg Mason, a brilliant analyst who doesn't miss a thing. "Thoughtfully crafted sentiment gauges such as the 'Crowd Sentiment Poll' from Ned Davis Research currently report record investor optimism, suggesting that most of the buying has already been done. And to see record optimism at a time when the S&P 500 has not even recouped half of its horrendous 2000-2003 losses -- and when the Nasdaq has barely recouped a quarter of its 77% decline -- would seem to make today's enthusiasm particularly ominous."
Russell Comment -- Markets can stay overbought for an extended period of time. But it is remarkable and uncharacteristic to see this market rise in the face of stubborn enthusiasm month after month. Even checking today, I see that the Investor's Intelligence poll of investment advisors shows 55.4% bullish while only 19.8% are bearish. Weekly new highs are at a record and the percentage of stocks above their 30-week moving average is also near a record high. To put it briefly, the stock market is amazingly overbought. But with it all -- no "sell signals" yet, although logic suggests that we should see one soon. |
