Marc Faber's latest newsletter:as always, MINUS charts(about 18 charts),text ONLY.
5/1/2008
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Why do Stocks Rally on bad News?
"When the Fed is the bartender,
everyone drinks until they fall
down".
Bob Hoye
There is no doubt that the economic news in the US is far from
encouraging. Consumer confidence has tumbled, numerous companies
such as Starbucks and UPS are reporting that conditions are the worst
they have seen since the 1990 recession and the housing market is a total
disaster with worse yet to come. Housing starts continue to exceed new
home sales with the result that the supply of new homes is at its highest
level since the 1981/82 recession. And the supply of new homes is still
rising! (See Figure 1)
Figure 1: Record Supply of New Homes
Source: Bridgewater Associates
How bad the conditions are in the housing industry is visible from the
number of foreclosures in California, which are up in the first quarter of
2008 by more than 4-times year-on-year (see Figure 2).
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Figure 2: Mortgage Foreclosures in California, 1988 - 2008
Source: The Los Angeles Times
What is interesting about Figure 2 is that in the last downturn in
Californian real estate “foreclosures” reached a record in 1996 when “the
Cumulative Real Change of Southern Californian Median House Prices
Since 1982” declined below zero (see also Figure 3, which we published
already in last month’s report). Since we can expect “the Cumulative Real
Change of Southern Californian Median House Prices Since 1982” to also
move in the current downturn toward zero or below zero, it would seem
that foreclosures will continue to increase no matter what monetary
measures the Fed implements!
Dr. Marc Faber Market Commentary May 1, 2008
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Figure 3: Cumulative Real Change of Southern Californian Median
House Prices since 1982
Source: Bruce Carman
According to David Rosenberg of Merrill Lynch, the recent “precipitous”
price drop in housing has failed “to elicit any pickup in sales. It is clear to
us from the latest new home sales report that the residential housing
market is nowhere close to the bottom. In spite of much lower prices,
sales failed to pickup and the inventory situation worsened. Moreover,
sales are running significantly below the pace of housing starts, which
reinforces our view that starts have to fall further before the inventory
situation will be addressed in any meaningful way.” I may add that so far
the media has focused on the dire conditions in the housing market and
the plight of homebuilders. However, we should also expect the
commercial property market to come under pressure because of reduced
demand for space by the retailing and the financial sector. One forecast I
am reasonably comfortable with is that for the next few years architects
will have a very rough time. According to the American Institute of
Architects (AIA), which publishes the Architecture Billing Index (ABI),
the March ABI fell to 39.7 - its lowest level since the survey was
commenced (see Figure 4).
Dr. Marc Faber Market Commentary May 1, 2008
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Figure 4: Architecture Billings Index, 1996 - 2008
Source: Fred Richards, Strategic Investing
It is clear that the downturn in housing is not only having an impact on
the homebuilding industry but is spreading to numerous other sectors of
the economy such as retailing (see Figure 5), housing related business
services and through the credit crisis to the entire economy. As Gail
Dudack observed, “job losses in construction, manufacturing, tradetransportation
& utilities, professional & business services, financial
activities and information technology are overwhelming the gains seen in
education & health services, government, leisure & hospitality, mining
and other services”. This is important because when the unemployment
rate increases default rates also increase. I would, therefore, expect loan
losses at financial institutions to rise substantially over the next 12
months or so. This is especially true in an environment in which credit
spreads have widened as much as they have over the last six months (see
Figure 6).
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Figure 5: Contracting Retail Sales in Real Terms
Source: Bridgewater Associates
Figure 6: Another Shoe to Drop: Credit Card Default Rates!
Source: Bridgewater Associates
As an aside, Target, the second-largest US discount chain, which is
reputed to run one of the tightest ships in the business in their credit card
operations, just announced that it wrote off 8.1% of its credit-card loans
in March compared to 6.8% in February and that it is in negotiation to sell
half its credit-card loans (thirty-day delinquencies are at their highest
rates since 2001). As for so many other companies, the credit card
Dr. Marc Faber Market Commentary May 1, 2008
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portfolio of Target was the main driver of earnings. Fourth-quarter
revenue from Target's credit-card portfolio had jumped 21 percent to
$532 million, significantly outpacing the company's total earnings gain of
just 0.8 percent (another reason to be skeptical about a strong corporate
earnings rebound in the second half of the year and in 2009).
I mentioned above that we should also expect the commercial
property market to come under pressure because of reduced demand for
space by the retailing and financial sector. Considering how commercial
real estate spreads have widened, commercial real estate default rates are
likely to increase over the next 12 two years very substantially (see
Figure 7)
Figure 7: A Further Shoe to Drop: Loan Losses on Commercial Real
Estate
Source: Bridgewater Associates
Since real estate related loans have risen over the last 15 years from 28%
of total bank loans to currently over 60% additional meaningful loan
losses related to construction and commercial real estate should be
expected. In short, the economic news is horrendous and is likely to get
much worse over the remainder of the year. In the past, the prevalence of
so much bad news was associated with major market lows after major
bear markets such as in 1974, 1982, and in 1990 and provided
outstanding entry points into the equity markets. However, what makes
the present situation unusual is that aside from financial stocks the stock
market is hardly down since the beginning of 2007. As I explained in last
month’s report the stock market seems to think that we are presently
Dr. Marc Faber Market Commentary May 1, 2008
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dealing with a financial crisis which is now already largely behind us and
which should affect the economy only moderately (see Figure 8, which I
am republishing from last month’s report for the benefit of our new
readers).
Figure 8: Ex Financials the Stock Market has held up!
Source: Morgan Stanley
As a result of the belief that the “worst is behind us”, and for other
reasons I shall explain below, market participants have remained, while
not exuberantly bullish, so at least complacent and optimistic about an
economic and corporate profit recovery in the second half of the year and
in 2009. According to a recent survey by Barron’s (see Barron’s of April
26, 2008), institutional investors are heavily leaning toward the positive
side. 50% of the respondents were either “very bullish” (7%) or “bullish”
(43%) about the US stock market whereas only 12% of respondents were
“bearish” (nobody was “very bearish” – see Figure 9).
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Figure 9: Barron’s “Spring 2008 Big Money Poll Results”
Source: Barron’s
There were another two interesting aspects regarding the “Spring 2008
Big Money Poll Results.” Institutional investors tended to be positive
about equities (87% indicated they would be buyers of equities in the next
three to six months), very positive about the US dollar and “very bearish”
about US Treasuries, and “bearish” about real estate, gold, and oil (see
Figure 10).
Figure 10: Favorite and Unpopular Asset Classes
Source: Barron’s
Moreover, institutional investors’ favorite industries over the next six to
12 months were “Financial” and “Technology” (see Figure 11).
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Figure 11: Favorite and Unpopular Industry Sectors
Source: Barron’s
To some extend I can understand why US institutions are positive
about US equities and the dollar, and bearish about treasuries. Because of
the US dollar’s steep decline since 2001 US equities are in Euro terms
still 50% below the peak in 1999 (in Euro terms - see Figure 12).
Figure 12: S&P 500 in Euro Terms, 1999 - 2008
Source: Bloomberg
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So, in Euro terms, US equities are relatively inexpensive.
In addition, because US equities sold off less than foreign markets
since October 2007 they have begun to out-perform foreign markets (see
Figure 13).
Figure 13: MSCI US versus MSCI World
Source: www.credit-suisse.com/techresearch
Then, as Walter Bagehot (who edited the Economist for 17 years) already
remarked in the 19th century, “John Bull can stand many things, but he
cannot stand 2%.” So, I have some sympathy with the positive stance of
institutional investors. However, I find it difficult to reconcile financial
institutions very negative stance toward Treasuries (only 3.6% of
respondents were bullish versus 62.2% who were bearish) and at the
same time their positive stance toward the economy and equities. The
reason I think there is an inconsistency here is that if interest rates
increase (Treasuries decline in value) the highly leveraged consumer
and with him the entire economy are unlikely to recover.
I am grateful to Bill King who publishes an outstanding daily market
up-date (mking7@bloomberg.net) for having attracted my attention to Dr.
Dr. Marc Faber Market Commentary May 1, 2008
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Steve Keen, an economist at the University of West Sydney who happens
to know a little about debt deflation. According to Keen,
“Fragility is indicated by the proportion of GDP needed to service
debt; the higher this proportion is, the less there is available to both
consume and invest. Economists habitually excuse any private borrowing
on the assumption that it will lead to increased output, and thus finance
itself. But 90% of the debt incurred in the past 3 decades has financed
speculation rather than investment. Productive capacity has risen far less
than debt, so that the debt ratio has grown exponentially.
All major OECD nations (except France) have experienced rising
private debt to GDP ratios over the past 3 decades. Australia’s debt ratio
rose 4.2% faster than GDP for the past 44 years—taking our ratio from
24% in 1964 (and 43% in 1977) to 165% now. The UK’s private nonfinancial
debt ratio was 96% in 1977, versus 243% now; the USA’s was
93% excluding finance, and 108% including, in 1977; today it is 170%
excluding finance, and 282% including.
These levels are unprecedented. The US private non-financial debt
to GDP ratio was 150% in 1929—20% below today’s level (it peaked
at 215% in 1932, due to Great Depression deflation of 10% p.a., and
falling output of 13% p.a…(emphasis added)
Recoveries from other financial crises in the post-WWII period have
worked because they have reignited the growth in private borrowing. I
doubt that there is any further capacity to do this: there are no subsubprime
borrowers to whom to lend. The growth in debt levels and asset
prices will reverse, and the change in private debt will therefore subtract
from demand rather than augmenting it” (see Figure 14).
In essence Keene shares similar concerns as I do. As Bridgewater
Associates notes “consumers who are up to their eyeballs in debt remain
unresponsive to lower interest rates” (see last month’s report and in
particular Figure 3 of that report)….. According to Bridgewater
Associates, “this is another indication that we are in a ‘deleveraging’
environment, not a normal recession.
We continue to see this in the credit numbers as well….
mortgage lending is down by about $1 trillion from the peak in the latter
portion of last year and business borrowing has dropped by about $600
billion from the middle of last year. Less borrowing means less spending”
(emphasis added).
The larger problem, however, is that in all Anglo-Saxon countries
“consumers are up to their eyeballs in debt” and that the problem of
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excessive debt is not endemic to the US but exists in all OECD countries
(certainly for the household sector – please note that Figure 14 aggregates
household and business debt).
Figure 14: Household & Business Debt to GDP
Source: Steve Keen, debtdeflation.com
So, what we are dealing with is not just a US credit bubble but a US
credit bubble, which has spread around the world and inflated almost all
asset markets into the stratosphere. In fact, some asset markets became or
are still far more inflated than US equities. I am thinking here of Chinese
and Indian equities and of real estate in Spain, the UK, Ireland, and
Australia where property prices are still rising – at least in Melbourne and
especially in Perth (see Figure 15).
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Figure 15: Real Home Prices in the US and Australia, 1980 - 2008
Source: Steve Keen, debtdeflation.com
As an aside, prime UK commercial property prices in the South-
East have slumped by around 25 per cent in the past two quarters,
with yields hardening from 4.5 to six per cent, an unprecedented shift
in property values estimated at a one in 15,000 year probability,
according to one of the UK’s top property consultants Strutt & Parker! (In
the first quarter, Strutt & Parker saw its own revenues tumble by more
than half, which is far better than the collapse in the UK commercial
property market to just 25 per cent of turnover in Q1 2007.) At a recent
event in Dubai Andy Martin, the head of Strutt and Parker’s Commercial
Division, was asked the question: “did this make UK commercial
property a buy?” he gave the obvious answer: “Only if you think the
impact of the crisis on occupancy will be zero!”
Aside from artificially low interest rates on US short dated Treasuries,
excessive optimism regarding an economic and profit recovery in the
second half of 2008 and in 2009, and dollar weakness, there are two more
reasons why US equities have held up well in face of deteriorating
Dr. Marc Faber Market Commentary May 1, 2008
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economic news. “Extraordinary monetary measures” by the Fed, which
drove real short-term interest rates into negative territory, have propelled
commodity prices higher (especially energy and agricultural
commodities) and boosted the shares of energy, industrial and material
stocks, which make up 14%, 12% and 4% of the S&P weight
respectively, far above their previous highs in 2007 (see Figure 16).
Figure 16: US Steel, 2003 - 2008
Source: www.decisionpoint.com
In addition, since households have to spend an increasing portion of
their income on non-discretionary items (necessities such as food and
energy), consumer staple companies, which make up 11% of the S&P
500, have also been strong (see Figure 17)
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Figure 17: Wal-Mart, 2006 - 2008
Source: www.decisionpoint.com
Considering all the above mentioned factors, I hope our readers will
understand why US stocks have held up so well – at least so far.
I have expressed the view in earlier reports that investors could buy
the S&P 500 below 1300 and sell it between 1400 and 1450. Since I
expect that the economy and corporate profits will badly disappoint over
the next six months and since we are now moving into the seasonally
weak period, I would use the current rebound as an opportunity to lighten
up on equities (see Figure 18). This applies also to emerging stock
markets.
Dr. Marc Faber Market Commentary May 1, 2008
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Figure 18: Performance of S&P 500 between November and April,
and between May and October
Source: www.chartoftheday.com
Another reason for taking an increasingly negative view about asset
markets is that the engines of global liquidity – the US trade and current
account deficits – are stuttering. Because consumption of discretionary
items is no longer increasing the US trade and current account deficits are
no longer expanding. Hence, while global liquidity is still there, it is no
longer expanding at an accelerating rate (see Figure 19).
Whenever the rate of growth of global liquidity is contracting asset
markets become vulnerable while the dollar should – at least in theory –
rally. I would, therefore, at least for now, refrain from shorting the US
dollar. In fact, I would aside from the Euro also expect commodity related
currencies (Canadian, Australian and New Zealand dollar) to weaken for
the next few months.
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Figure 19: Inverse Correlation between the Growth Rate of
FRODOR and yearly Percent Change in Major Currencies!
Source: Ed Yardeni, www.yardeni.com
And while I find it extremely difficult to make a fundamentally strong
case for owning the US dollar (it also makes me nervous that so many
institutional investors are positive about the dollar – see Figure 10) based
on a relative tightening of global liquidity (see Figure 19) a small short
Euro position is recommended with a tight stop loss order (see Figure
20).
As an aside, please also note the extended weakness of the dollar since
the Fed began to cut rates in September 2007! Mr. Bernanke’s monetary
policies amount to nothing else but a complete debasement of the
currency! But not surprisingly – given the educational levels in the US –
Mr. Bernanke receives high marks for how he handled the financial
crisis….
Dr. Marc Faber Market Commentary May 1, 2008
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Figure 20: Euro Index, 2007 - 2008
Source: www.decisionpoint.com
Gold is correcting and I hope that its price will retreat further. I would
consider any weakness toward $ 800, which is far certain from
happening, to be an excellent entry point. |
