Thursday, September 11, 2008

Very Modest Good News

Very Modest Good News

By Dr. Marc Faber | 11 August 2008

I can see some— albeit very modest— improvement for the US stock market. For one, it appears that the slowdown and problems in other economies, such as the UK (a disaster waiting to happen), Italy, Spain, and Ireland, [[and Chindia and the Far East: normxxx]] are even greater than in the US. Also, since numerous emerging stock markets have underperformed the US this year, some money is likely to be repatriated from countries such as India and China, where stock markets are down approximately 40% year-to-date. We should also consider that, as Joachim Fels noted, "Fifty of the 190 or so countries in the world now have inflation running at double-digit rates. Almost all of these are EM economies." In my opinion, some emerging economies— contrary to expectations— could therefore be hit even harder than the US. So, the good news here is that the "bad news" is even worse in some other countries than in the US (though this may be hard to believe).

The media and some market commentators who were "bullish" until late June have noticed recently that we are in a bear market, probably because the major indices are down roughly 20% from their peak [[although now they are calling a "bottom" for this bear market: normxxx]]. This is a remarkable achievement in the annals of forecasting and market timing! How many stocks had to drop by between 50% and 99% before the media and some "bulls" who have continued to talk about another upward wave in stock prices being 'just around the corner', which would supposedly lift the indices to new highs, finally accepted that we are now in a bear market?

Don't forget that when stock market indices made new highs seven months ago, the media and most advisers were exuberantly optimistic— although most stocks were then already in downtrends. Moreover, sentiment figures (bulls versus bears) among individual investors and investment advisers are now heavily tilted towards the bearish side. Whenever sentiment has been this negative in the past, the odds favoured at least a short term rally. Still, I need to warn our readers that since sentiment remained so extremely optimistic between 2003 and 2007 while the stock market rose, it is just possible that sentiment will remain extremely negative for a long time while the market continues to decline.

The third improvement I have noticed is that, from a technical point of view, the market has become "quite" (though not extremely) oversold. But again, I need to warn here that the market would now be oversold in the context of a bull market— not in the context of a bear market, during which the oversold condition could last for a very long time. I suppose that Ambac was already oversold at US$70, and where did it eventually bottom at? Moreover, at major turning points, markets can quickly reach oversold or overbought conditions and then work out these conditions without large corrections. Let me explain.

In the summer of 1982, US equities had become extremely depressed; they were no higher than in 1964, and in real terms were down by more than 70% from their 1966 "real" high. The Dow bottomed out at 769 on August 9 and, if I recall correctly, the stock market took off on August 18. By September 22, the Dow had reached 951 (up more than 20% from the August low). The two most overbought conditions I have seen up to that time had occurred at the end of August 1982, and then again on September 22. But, thereafter, the market continued to rise: to 1296 in November 1983, to 2746 at the August 1987 peak, and to the recent high of 14,198 on October 12, 2007.

So, I wish to stress that overbought and oversold conditions must always be put in the context of both the primary trend— up or down— and the phase of the bull or bear market in which they show up. Overbought conditions at the beginning of an uptrend, and oversold conditions at the beginning of a downtrend, are meaningless from a longer-term perspective! If we are indeed in a bear market, which is my view— and has been since the summer of 2007, the current oversold position is relevant only from a very short-term point of view.

The fourth improvement I see is that some previously strong stocks and groups such as US Steel (X), Cleveland-Cliffs (CLF), IBM, and the oil sector, as well as the Nasdaq and some of its leaders such as Research in Motion (RIMM), Apple (AAPL), etc, are beginning to turn down. For the market leaders to collapse is an important precondition for a major low. But again, we need to understand that it will take much longer, and far lower prices, before the very strong stocks and sectors (mostly energy-related and materials) that have so far defied the bear market in financial stocks reach a major low.

Since I fully expect the financial crisis to spread into the real economy, I would sell those sectors and stocks that have so far defied the weakness in financial stocks. Another potentially good piece of news is that the current expansionary monetary policies make the stronger companies in an industry relatively stronger than their weaker competitors, which would then be reflected in strongly diverging stock performances. The weak company stocks could decline so much as to make them, at some point, attractive merger and acquisitions candidates for the financially stronger companies. Industry consolidation would in this scenario accelerate and lead to stronger pricing power (and inflation).

The last potentially good bit of news is that oil and other commodity prices may have reached an intermediate top. Should oil prices decline by, say, 20% to 40%, this fact will certainly be broadcasted by the media— as well as by ignorant cheerleaders and people who still don't regard commodities as an asset class— as great news for the stock market! A relief rally would likely follow. But wait a minute: why would oil prices and other commodities decline meaningfully?

Because of a lack of affordability and a weak economy around the world— not just in the US! This would lead to declining demand for raw materials and likely lower prices. (Supplies are unlikely to increase significantly, but they could be cut as a result of war, civil strife, or concerted action by the producers.) However, a weak economy or economic contraction around the world would be unlikely to be favourable for equities and corporate profits.

I need to make one more comment with respect to oil prices and commodities. It is not a strong US dollar that will lead to declining oil prices, as some commentators argue. What will bring about lower oil prices is a collapse of consumer spending in the US and elsewhere in the world. If US consumption collapses, the US trade and current account deficit will be halved and will lead to a drying up of global liquidity.

I have discussed this relationship many times in the past and have clearly shown the relationship between the growth rate in Foreign Official US Dollar Reserves and the US dollar. Declining US consumption will be positive for the US dollar and will certainly bring down commodity prices because of lower demand (at least temporarily). But if you really think that such an outcome will be good for stocks, then dream on!

Finally, since the bull market in commodities began, there has been a body of people who have maintained that commodities are not an asset class. Some have even gone as far as to compare gold to washing machines. But consider the following: my dogs and my books are an asset for me, but maybe not to someone else. My dogs protect my house and my books. My books give me pleasure and— so I hope— some modest knowledge. But my dogs would be a liability to someone else if he lived in a secure condo building. (If there is such a thing as a secure condo building!)

Also, my books would be useless to an illiterate person, since he would not be in a position to read them. A high-calibre mathematician is likely to be an asset for James Simons of Renaissance fame, but a huge liability in a rescue mission on Mount Everest. Water may be a huge asset if you are lost in the middle of the desert, but it is not an asset when you are standing in the rain without an umbrella and waiting for a date to arrive. So, the first point to understand is that anything can be an asset for somebody at some time, and not an asset for somebody else at some other time. Normally, cigarettes are not considered to be an asset, but in prisoners' camps during wars, in wartime in general, and in times of hyperinflation, they are an asset— in fact, they replace cash banknotes.

Now, if someone defines an asset class as something that provides a cash flow, commodities may by this definition not be an asset. However, what if asset markets such as equities, bonds, and cash (T-bills) provide a negative return in real terms (inflation adjusted)? The moment when money loses its purchasing power because real interest rates are negative, and because we need to deal with people like Mr. Bernanke, assets such as raw land, commodities, art and collectibles do become a store of value and, therefore, represent a desirable asset class.

All I wish to say is that the term "asset class" is extremely difficult to define, and that at different times and in different situations certain things and certain skills become an asset, whereas on other occasions they are useless. But one thing all my readers should clearly understand: when the last ship leaves the port as the enemy approaches, the captain of that ship will accept one kilogram of gold from you to buy your passage. I doubt that he will accept CDOs, derivative contracts, bonds or, for that matter, stock certificates of Fannie Mae or Freddie Mac. (Maybe by then the captain won't even accept US dollars, because their value could decline precipitously during the voyage.) I may add that, in the financial sector, the last ship may be about to leave.

In sum, I believe that in the next few years the returns from equities will be disappointing (short-term rallies aside), which could cause other asset classes (especially industrial commodities) also to come under pressure. When I look around, I find it hard to identify any asset that is particularly attractive at this point. Therefore, in the absence of anything that promises far superior returns, I am still happy to accumulate physical gold. In democracies, where the leadership is afraid to ask for sacrifices from its citizens and with money printers at central banks, gold would seem to be the only sound currency.



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The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

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