gipa69
collegio dei patafisici
July 6, 2006
by Marc Faber
Chiangmai, Thailand
Corrections or Bear Markets in Asset Prices?
INTRODUCTION
BASED ON THE number of e-mails I receive and the types of questions I get asked, I have a fair idea of how investors are positioned. It is my impression, therefore, that the recent sudden sell-off in asset markets came as a surprise to the majority of investors and caught them - at least temporarily - on the wrong foot.
The most frequently asked questions came from India, where the market sold off within a few days by 20% from its high (it has since recovered modestly), and from Middle Eastern investors who were stunned when their stock markets declined by about 50% from their peak in late 2005 (see Figure 1). The decline in the Middle Eastern markets is remarkable because it occurred in an environment of near-record oil prices and at a time when liquidity was still increasing.
The best explanation I have for the decline in those markets is that, whereas Middle Eastern liquidity is still plentiful, the rate of growth has been slowing down. As my friends at GaveKal Research pointed out, "Bull markets, to keep going, need an ever growing stream of liquidity; for copper to rise 10% from US$2,000/ton to US$2,200/ton takes a little amount of money while a rise from US$8,000/ton to US$8,800/ton usually takes a lot more. In that respect, bull markets are like drug addicts whose next fix/liquidity injection provides diminishing returns. To get the same effects, the fix/liquidity injections need to always get bigger... Or serious withdrawal follows."
The diminishing rate of liquidity growth aside, there may have been other reasons why stock markets in the Middle East tanked. The best time for equities tends to be at the end of an economic contraction or at the beginning of an expansion, when there is plenty of excess capacity. It is at these times that there is maximum liquidity in the system and, in the absence of heavy capital spending, stocks soar.
But once an increasing quantity of money is channelled from the financial sector into real economic activity - in the case of the Middle East, into grandiose residential and commercial construction projects and Ferraris - stocks frequently begin to stall or to decline abruptly. I mention this fact because the consensus among investors is that the global economy is booming. It is certainly the case that the boom is unprecedented in the history of capitalism.
Consider this: for the first 150 years of capitalism until the Second World War there was a colonial system in place. Under the colonial system, the rich industrial countries of the West (partly misguided by mercantilist economic policies) had little incentive to boost economic development and progress in the colonies.
The colonies were used principally to source raw materials, which were then processed into manufactured goods in the industrialised countries before being again exported to the colonies at high prices. These economic policies of imperialism led, in some cases, to a process of de-industrialisation in colonies such as 19th-century India. So, for the first 150 years of capitalism, the world didn't experience strong, synchronized growth.
Then, following the breakdown of the colonial system during and immediately following the Second World War, close to 50% of the world's population fell under communist and socialist rule, or had in place policies of "self-reliance" and "hostility towards foreign investors".
Under these socialist systems, economic policies designed to stimulate the consumption of "butter" were avoided - largely at the expense of building an arsenal of heavy "guns" and unproductive heavy industries.
Following the breakdown of the socialist/communist ideology, which began with China's Open Door Policy in 1978, the former socialist countries began to grow rapidly but in terms of size remained insignificant in the context of the global economy. In the 1980s, the Latin American countries went through a serious inflationary recession/depression, while declining oil prices took their toll on Russia and the Middle East.
Then, in the 1990s, Latin America began to recover strongly just as the world's second-largest economy - Japan - went into a non-growth phase that lasted until just recently. At the same time, the Asian crisis of 1997 and the Russian crisis of 1998 lowered demand from Asia and the former Soviet Union.
By contrast, look at the global economy today! US consumption is strong - in fact, so strong that it has led to an exploding trade and current account deficit. In turn, these growing deficits have greased the world with liquidity and boosted economic growth rates through capital spending and industrial production, particularly in the Asian region.
An Asian consumption boom has followed, driven largely by employment gains, huge productivity improvements in China, and declining prices for manufactured goods, which significantly enlarged their market potential. A consequence of this boom in the Asian economies - and, in particular, in the Chinese economy - has been a significant increase in the demand for commodities, which has lifted the economies of Latin America, Africa, the Middle East, and the former Soviet Union.
At the same time, Europe has experienced an export-led recovery, driven by the emerging world, and Japan, also partly driven by exports, has begun to grow once again.
I admit that the above historical perspective is simplistic, but my point is that, today, we can say that - at least from an economic perspective - "this time is different". It is a fact that we are truly in the midst of an unprecedented global synchronized expansion. And not only that!
The expansion is reaching just about every corner of the world and almost every sector of its economy - admittedly, however, at different intensities. Still, as I have repeatedly pointed out in earlier reports, the current global economic boom is characterised by huge and growing imbalances. Steve Roach believes that these imbalances can be solved benignly, but I believe there will be some serious rebalancing consequences.
Are Financial Assets the First Victims of the Current Economic Boom?
It is important to understand that even when central banks expand liquidity at an ever-increasing pace (Weimar hyperinflation, Latin America in the 1980s, Zimbabwe now), liquidity does tighten temporarily from time to time, as price and wage increases outpace money supply increases. So, whereas the German stock price index rose in paper marks from 100 in 1913 to 26 trillion in 1923, there were 20% short-term corrections (lasting usually just two months) in 1920, 1921, and 1922, and a 25% correction in 1923 (in US dollars).
(However, the index fell from 100 to a low of 2.72 in 1922, before recovering to 26.80 in December 1923.) As GaveKal Research pointed out (see above), in order to sustain a bull market in asset prices, an everincreasing pool of liquidity is required and this is, in the short run, impossible for a central bank to achieve - even if its intentions are "to print money". In the example of the Middle Eastern stock markets referred to above, the prime drivers of liquidity are obviously oil production and oil prices.
From Figure 4, we can see that between 2002 and 2005, oil production soared from 25 million barrels a day to around 31 million barrels. The increase in production was accompanied by strong price increases. (Crude oil prices rose from $19 a barrel to $70.) However, at the end of 2005, oil production began to decline moderately and oil prices no longer rose. So, whereas liquidity was still plentiful, the rate of increase declined and led to a relative tightening of monetary conditions, which I suppose explains the dismal performance of the Middle Eastern stock markets over the last six months.
Aside from the Middle East, it is apparent that liquidity conditions around the world, while still expansionary, are less expansionary than in the 1999-2005 time frame. (Remember that it is the rate of change that matters the most.) From Figure 7, courtesy of Ed Yardeni, we can see that while bond yields are still below nominal GDP growth, they are no longer declining relative to nominal GDP growth, as they did between 2001 and 2004. So, we could argue that while an absolute tightening has not yet taken place, a relative tightening has been in force for the last 12 to 18 months. This would also seem to be confirmed by two other monetary indicators.
While Foreign Official Dollar Reserves are still expanding at an annual rate of 15% (no absolute tightening here), they are no longer increasing at an accelerating rate such as was the case between 2002 and 2005 - hence, a relative tightening is under way.
Now, whenever central banks create excess liquidity, symptoms of inflation will show up somewhere. Sometimes wages and consumer prices will react the most to expansionary monetary policies (for example, the 1960s and 1970s), but in today's world where, given the low wages in China and India, an almost unlimited labour arbitrage can take place, easy monetary policies drive asset prices such as homes, commodities, equities, art, and so on, higher, while wages and consumer prices rise only with a lengthy time lag (once commodity prices begin to be passed on in the prices of finished manufactured goods).
Therefore, it should come as no surprise that, when liquidity growth is slowing down, asset prices begin to cave in first. This is especially true of equities, since the stock market discounts economic events well ahead of time. In this respect, it is interesting to note that while home prices in the US have continued to rise nationwide, homebuilding shares peaked out in the summer of 2005.
Since I wrote extensively about the homebuilding industry last year, I shall refrain from making additional negative comments here, except to say that conditions have since deteriorated badly, with the number of total single-family homes available for sale (existing and new single-family homes) rising to a record high (see Figure 12, courtesy of David Rosenberg and Richard Bernstein). At the same time, the Home Buying Intentions Index is at its lowest level since 1991. I might add that when homebuilding shares peaked in the summer of 2005, analysts remained very positive on this sector.
But, as I have repeatedly pointed out, it usually pays to listen to the market. And in this respect, we should take rather seriously the sharp break in equity and commodity prices, as well as in some of the emerging market currencies, that we experienced in the second half of May. The break may prove to be only of very brief duration with new highs to follow, but the impulsive nature of the break suggests differently - at least for now.
Naturally, investors will immediately ask why stocks and commodities should sell off when we are in the midst of a global synchronised economic expansion, when corporate profits are still expanding. The point is that, precisely because we are in a global boom, liquidity is likely to become tighter for a while and that, as just outlined, in such an environment equities and other asset prices are vulnerable until liquidity conditions improve once again.
Another reason for the sell-off could be accelerating inflation, about which we have frequently commented in recent reports and which may have a very negative impact on discretionary spending and corporate profitability, and could even lead to a global recession with some time lag. I hope that our readers will have noticed that their cost of living is not currently rising by "core inflation" but by between 5% and 6% per annum. (The US Cleveland Fed Median CPI rose in April at an annual rate of close to 6%.) Other reasons for the sudden decline in equities could be the threat of a pandemic or geopolitical tensions, which could lead, if not to a military conflict, then possibly to a trade war or competitive devaluations. It is important for investors to understand that when markets begin to move sharply in the opposite direction of the prevailing trend - that is, from down to up or from up to down, as was the case just recently - the reason for the trend reversal is usually not known for quite some time.
But a well-established fact is that equity bull markets get under way amidst dismal economic and financial conditions, while bear markets begin when everything looks at its brightest, such as was recently the case (at least superficially). Moreover, the more speculation there was in a market, the more likely it is that the correction could be serious and take the proportions of a bear market (down 20-40% or more).
Near - and Longer-Term Considerations
I have to confess that I did hesitate for a long time before deciding to commit to paper the following observations, as they will undoubtedly cause some confusion, given the views I have expressed in earlier reports. However, there are times when, within a long-term view, short-term considerations become more significant. From a longer-term perspective, I still maintain that central banks - especially the US Federal Reserve - will have no other option than to print money and that, therefore, in the long run, asset prices will continue to increase - at least in nominal terms.
US MZM has soared as a percentage of GDP in recent years and, as in the case of Japan, has created a huge monetary overhang. And while monetary conditions have tightened relatively in both Japan and the US, because money supply is no longer expanding as a percentage of GDP, looking at credit growth there can be no question that monetary polices are still expansionary. I am grateful to Kurt Richebächer for having recently pointed out that, in the US, in the fourth quarter of 2005, non-financial credit expanded at a new annual record rate of US$2,445.7 billion.
According to Richebächer, this compares with US$1,710.5 billion in the second quarter of 2004, at the end of which the Fed started its rate hikes. Financial credit increased US$1,224.4 billion, as against US$932.7 billion in the second quarter of 2004. In aggregate, overall financial and non-financial credit growth accelerated over this period of rate hikes from US$2,643.2 billion in the second quarter of 2004 to US$3,670.1 billion in the fourth quarter of 2005. In percentage terms, borrowing and lending increased a staggering 38.9%.
According to Richebächer, "the fact to see is that all the rate hikes were undertaken in [the] complete absence of any monetary tightening. Plainly, the Fed has readily provided any bank reserves that the financial system has needed to maintain its credit expansion. It is a farce of monetary tightening. For all of 2005, total credit expanded by $3,340 trillion, to $40,230 trillion, up more than $500 billion from 2004's record $2,818 trillion increase. For comparison, annual total credit growth averaged $1,237 trillion during the 1990s. Trying to capture the dynamics, we compare the credit expansion with the simultaneous increase in real and nominal GDP. Well, in real terms, it was up $378.9 billion in 2005, and in current dollars, 751.4 billion."
So, in order to generate nominal GDP growth of US$751 billion, in 2005, total credit market debt had to increase by US$3,340 trillion - 4.4 times faster than GDP. Now, as is the case for the current account deficit, which hovers around 7% of GDP at present, the optimists will say that debt growth that is four times larger than GDP growth is sustainable. This may be the case for now, but the point is that, in the 1950s and 1960s, debt and GDP grew at about the same rate, with the result that in 1980, when Paul Volcker tightened meaningfully, total credit market debt was "only" about 130% of GDP.
Then, in the 1980s, debt grew at about two-and-a-half times GDP, in the 1990s at about three times GDP, and now at more than four times. In other words, as GaveKal Research pointed out, in order to sustain the asset bull markets and the economic expansion, debt growth will have to accelerate soon to initially five times GDP, later to six times, and if we extrapolate the trend that has prevailed since the 1960s, eventually to more than 20 times GDP.
Similarly, the current account deficit, which grew from 2% of GDP in 1998 to around 7% of GDP, would have to triple to around 20% of GDP in the next five to seven years in order to sustain the growth rates in foreign official dollar reserves (global liquidity) and economic growth around the world, if the recent trend is extrapolated. Also not forgotten is the US saving rate, which declined from an average of 9% in the 1970s to less than zero at present and turbo- charged the economy. If the stimulative economic impact of a declining saving rate is to be maintained, the saving rate will eventually have to be at around -10%.
Now, you don't need to be an economist with a Harvard education to see that these trends are not sustainable in the long run. However, it is my belief that the Fed, and other central banks which are at least as agile at printing money as the Fed is, will try to postpone the hour of truth by a renewed massive liquidity injection when the next recession arrives. So, my concern remains the same: before the final debt crisis hits, we might see very high rates of inflation - most likely hyperinflation, with all asset and consumer prices soaring (amidst falling real incomes).
July 7, 2006
by Marc Faber
Chiangmai, Thailand
Corrections or Bear Markets in Asset Prices, Part II
YESTERDAY'S EDITION is a long-term forecast. Near term, I envision a scenario whereby credit growth slows down and the economy moves into either a very low-growth or recessionary phase.
Why? Since US debt growth has driven asset prices higher in the last few years and allowed US households to extract funds from their assets in order to sustain increasing consumption, it is likely that home and stock prices, which will no longer rise and more likely may go down, will have a pronounced impact on economic growth rates. In this respect, it is important to understand the following. While the Fed fund rate has increased from 1% in June 2004 to 5% at present, lending standards in the housing industry have continued to decline.
This was one reason why debt growth has accelerated since the second quarter of 2004, as Kurt Richebächer demonstrated above. In fact, Bridgewater Associates produced recently a very telling figure showing what has been happening in the housing industry since 2002. Mortgage borrowings have begun to rise at a much faster clip than residential construction (see Figure 15). (I am sure the optimists will think that this trend is also sustainable.)
As Jason Rotenberg of Bridgewater Associates points out, the difference between mortgage borrowing and residential construction is the "largest ever" and shows by "how much housing has added to growth in recent years through mortgage borrowing (with over a third of that money flowing to non-housing spending) and construction".
Now, here is the bad news. First, the dismal performance of homebuilding shares since last summer, given their low valuations, seems to indicate that conditions in the housing market are likely to be far worse than the official statistics suggest. Two, as Bill King pointed out in one of his recent daily missives, and quoting the Chicago Tribune , mortgage defaults are on the rise.
According to the Tribune , "In Illinois during the first three months of 2006 nearly 13,700 properties entered foreclosure, up 32% from the fourth quarter of 2005, according to an analysis by property tracker RealtyTrac Inc. The numbers are grimmer elsewhere in the Midwest. Michigan and Ohio, battered by automotive-related job losses, together recorded 45,000 mortgages entering some stage of foreclosure in the first quarter.
Those are increases of 91% and 39%, respectively, compared with last year's fourth quarter. Nationally, foreclosures are up 38%, higher than in any quarter of last year, RealtyTrac said... 'The increases we've been seeing in foreclosures don't even reflect the worst-case scenario that could happen when the $2.7 trillion in adjustable-rate mortgages are reset over the next 18 months' said Rick Sharga, vice president of marketing at RealtyTrac" (emphasis added).
No matter how optimistic (or desperate) bank and sub-prime lending officers might be, I suppose that, at some point, even these optimistic folks will do the totally unthinkable and tighten lending standards somewhat, as they did in the early 1990s. Also, given the high level of adjustable-rate mortgages that will be reset in the next 18 months, it is difficult to see how much tighter the Fed can become!
Nevertheless, housing, the most significant driver of the economy in this expansionary phase that began in November 2001, is unlikely to provide much economic stimulus in future. Granted, some observers will contend that a housing slowdown will be offset by an increase in salaries and wages, but such an increase would also lead to higher inflation and make it next to impossible for the Fed to cut interest rates.
In short, whereas I do expect central banks to embark anew on massive "money printing" in future, and to flood the system with even greater liquidity injection than they have done since 2001, for the next three to six months or so, global liquidity may not rise sufficiently to keep the global economy on its growth trajectory and asset prices from declining.
An Attempt to Structure a Shorter Term Investment Strategy
My readers will know from past reports that I am a firm believer that central banks will print money to save the system from imploding under the ever-increasing economic and financial imbalances. Therefore, under a money-printing regime, the Dow can easily rise over the next six to ten years to 33,000, while it loses value in real terms (that is, against gold - with the result that sometime in the future one Dow Jones Industrial Average will only buy five ounces of gold or less).
Obviously, under these conditions, the US dollar will also lose value against gold and against the currencies of countries that are endowed with a more responsible central bank (Switzerland - I hope...) or which are economically far more competitive than the US (China). Needless to say, in a money-printing environment, 30-year US government bonds will be one of the worst possible investments. But, this is all in the long term. For the next six months or so I envision the following.
Equities around the world will weaken further and US home prices will decline. US consumption will slow down or could even temporarily decline, as consumer sentiment turns decidedly down and leads to an increase in the saving rate. Corporate profits will begin to disappoint badly as the huge financial gains that boosted profits in the last four years no longer grow, or decline.
As a result of a US consumption slowdown, the US current account deficit, which flooded the world with liquidity, will no longer expand at the same rate as between 1998 and 2005 (or possibly even may contract temporarily), thus withdrawing an important source of liquidity to the world. Foreign economies will slow down or run into some problems as industrial commodity prices sell off, or no longer increase. This will add to a "relative" tightening of monetary conditions. (Remember what happened to the Middle Eastern stock markets.)
In asset classes jargon, the above scenario, which I expect to unfold over the next few months, would imply the following:
US bonds , an asset class about which most investors have been very negative recently, could rally somewhat, as economic news begins to disappoint and as there is a modest flight to safety. In addition, portfolio managers and the asset allocation crowd (or momentum players) who successfully rode the 2002-2006 bull market in global equities and achieved total returns in excess of 100%, may opt to raise some cash and shift from equities into short-term bonds.
The US dollar could benefit from a reduction of risk appetite among the investment community, as the money that chased high yields and high returns in countries such as Brazil, Indonesia, Turkey, and India, to mention a few markets, is repatriated. I have to admit that this is a low-confidence forecast, since a weaker economy in the US could also adversely affect the US dollar. (In addition, I would expect the US dollar index eventually to break down below its support around 80.)
US equities have broken down from a rising wedge with heavy volume and with significant momentum (see Figure 18). The technical implications are usually bearish and further downside risk exists. Also, as can be seen from Figure 18, huge overhead resistance now exists for the S&P 500 between 1280 and 1325. As I pointed out in the April report, entitled, "A Simpleton's Guide to Economics and Investment Markets", the Dow Jones seems to have traced out a "three peaks and the domed house" formation from where a significant decline usually follows. In addition, the "Hindenburg omen" gave several sell signals in late April.
Sell signals do occur when unusually large numbers of stocks both reached one-year highs and lows but prices continue to climb. The Hindenburg omen sell signals occur only seldom. They indicate a highly unstable stock market. Whereas their record is not perfect, Hindenburg omen sell signals preceded the crash of October 1987, the Long-Term Capital Management collapse of 1998, and the bursting of the "Internet bubble" in 2000.
Emerging market equities , which were not only the crowd trade of 2005 and early 2006 but which also became extremely overextended, are among the most vulnerable asset classes over the next few months. The Istanbul Stock Exchange National 100 Index dropped in a few days by 25%, while Russia, India, and Brazil were off by about 20% (see Figures 19 and 5). I should like to remind our readers that no matter how favourable the fundamentals of an economy appear to be, equity markets can be totally out of step with the economy - as was the case for Chinese equities between 2002 and 2005 when they fell by 50%.
Emerging economies' currencies have also suddenly begun to weaken. The Turkish Lira lost 15% within just a few days, and the Brazilian Real fell by an almost equal amount. Currency weakness and slumping stock prices led to a double whammy for investors in these countries. Some readers may wonder what caused these emerging economies' currencies to suddenly weaken. In Latin America, a populist socialist move is well under way, and in many other emerging economies the domestic price level has increased very significantly in the last few years. In the case of Thailand, my impression would be that prices have increased by about 50% over the last four years - admittedly, from an extremely low level. Another reason for currency weakness among emerging economies may have to do with the "flight to safety" referred to above, and with an impending decline in commodity prices.
Industrial commodities are vulnerable to a global economic slowdown. Granted, we are in an environment where almost all economies of the world are expanding, but this is the situation today, now! Driven by declining asset prices, the global economy could slow down abruptly and lead to temporary disappointing demand for industrial commodities. At the risk once again of being wrong, I still believe that copper prices have a significant downside risk (see Figure 21). Gold prices could come under further pressure, but the monetary aspect of gold should probably lead to an outperformance of gold compared to industrial commodities whose prices depend on global economic growth. Still further weakness to below US$600 per ounce wouldn't surprise me. Among the commodities, complex agricultural commodities may entail the lowest risk. However, when asset markets come under pressure, all assets can suffer - though obviously to varying degrees. In this respect, I would avoid the purchase of the overhyped and momentum-driven ethanol stocks for now.
Residential real estate , especially in the high-end condominium market, also appears to have considerable downside risk. Compared to a few years ago, during my travels I am now seeing a surprising number of cranes building trophy condos in urban centres all over the world, as well as trophy second homes in resort areas. When the Asian crisis occurred in 1997, it hit well-to-do people the hardest (the leveraged large asset holders). Now, looking at the immense profits the "money" and other "asset shufflers" such as real estate speculators and private equity managers have achieved (not to mention the CEOs), I wouldn't be surprised if, for a while at least, a payback time dawns upon the financial industry and the (in my opinion) overpaid CEOs. A good contrary indicator may be The Economist's April 29 - May 5, 2006 issue, which had on its cover: "On top of the world - Goldman Sachs and the culture of risk". It is worth noting that Goldman Sachs' shares topped out in a most timely fashion on April 20 and formed a "head and shoulders" between early April and mid-May.
Furthermore, I was pleased to read that, last year, some of my friends earned in excess of US$500 million. (According to the Financial Times of May 26, 2006, the top 26 hedge fund managers earned US$363 million, on average, in 2005.) As I indicated in earlier reports, whenever there is a concentration of earnings in one sector of the economy - in this case, among us "money shufflers" - and our great achievements make headlines in the media, the end is near for that sector!
(I would be surprised if there were any fund or hedge fund managers in the 1970s who earned more than US$10 million per annum - another sign of how money has lost its purchasing power - read "inflation".) Of course, there is hope for our financial nirvana: Mr. Bush just appointed Henry (Hank) Paulson, former CEO of Goldman Sachs, as US Treasury Secretary. And guess whose interest he is more likely to protect? The common man, the workers, the middle class - or his buddies on Wall Street?
So, I am looking forward to the time when my friends among the top hedge fund managers will - thanks to another "money printer" in the current US administration, a group of politicians whose superior intellectual capital far outweighs the negative impact of the US current account deficit - earn a trillion dollars each. (By then, an ounce of gold will probably sell for around US$1 billion, while billionaires will be about as common as millionaires are today.)
But, let us hope for now that the market's reaction to the appointment of Mr. Paulson won't be as negative as it was following the appointment of the chief money printer to the Fed, when both bonds and the dollar subsequently tanked.
In any event, for now, as outlined above, I see some dark clouds hanging over the financial and luxury goods sector, including the art, collectibles, and trophy wife market.
Regards,
Marc Faber
by Marc Faber
Chiangmai, Thailand
Corrections or Bear Markets in Asset Prices?
INTRODUCTION
BASED ON THE number of e-mails I receive and the types of questions I get asked, I have a fair idea of how investors are positioned. It is my impression, therefore, that the recent sudden sell-off in asset markets came as a surprise to the majority of investors and caught them - at least temporarily - on the wrong foot.
The most frequently asked questions came from India, where the market sold off within a few days by 20% from its high (it has since recovered modestly), and from Middle Eastern investors who were stunned when their stock markets declined by about 50% from their peak in late 2005 (see Figure 1). The decline in the Middle Eastern markets is remarkable because it occurred in an environment of near-record oil prices and at a time when liquidity was still increasing.
The best explanation I have for the decline in those markets is that, whereas Middle Eastern liquidity is still plentiful, the rate of growth has been slowing down. As my friends at GaveKal Research pointed out, "Bull markets, to keep going, need an ever growing stream of liquidity; for copper to rise 10% from US$2,000/ton to US$2,200/ton takes a little amount of money while a rise from US$8,000/ton to US$8,800/ton usually takes a lot more. In that respect, bull markets are like drug addicts whose next fix/liquidity injection provides diminishing returns. To get the same effects, the fix/liquidity injections need to always get bigger... Or serious withdrawal follows."
The diminishing rate of liquidity growth aside, there may have been other reasons why stock markets in the Middle East tanked. The best time for equities tends to be at the end of an economic contraction or at the beginning of an expansion, when there is plenty of excess capacity. It is at these times that there is maximum liquidity in the system and, in the absence of heavy capital spending, stocks soar.
But once an increasing quantity of money is channelled from the financial sector into real economic activity - in the case of the Middle East, into grandiose residential and commercial construction projects and Ferraris - stocks frequently begin to stall or to decline abruptly. I mention this fact because the consensus among investors is that the global economy is booming. It is certainly the case that the boom is unprecedented in the history of capitalism.
Consider this: for the first 150 years of capitalism until the Second World War there was a colonial system in place. Under the colonial system, the rich industrial countries of the West (partly misguided by mercantilist economic policies) had little incentive to boost economic development and progress in the colonies.
The colonies were used principally to source raw materials, which were then processed into manufactured goods in the industrialised countries before being again exported to the colonies at high prices. These economic policies of imperialism led, in some cases, to a process of de-industrialisation in colonies such as 19th-century India. So, for the first 150 years of capitalism, the world didn't experience strong, synchronized growth.
Then, following the breakdown of the colonial system during and immediately following the Second World War, close to 50% of the world's population fell under communist and socialist rule, or had in place policies of "self-reliance" and "hostility towards foreign investors".
Under these socialist systems, economic policies designed to stimulate the consumption of "butter" were avoided - largely at the expense of building an arsenal of heavy "guns" and unproductive heavy industries.
Following the breakdown of the socialist/communist ideology, which began with China's Open Door Policy in 1978, the former socialist countries began to grow rapidly but in terms of size remained insignificant in the context of the global economy. In the 1980s, the Latin American countries went through a serious inflationary recession/depression, while declining oil prices took their toll on Russia and the Middle East.
Then, in the 1990s, Latin America began to recover strongly just as the world's second-largest economy - Japan - went into a non-growth phase that lasted until just recently. At the same time, the Asian crisis of 1997 and the Russian crisis of 1998 lowered demand from Asia and the former Soviet Union.
By contrast, look at the global economy today! US consumption is strong - in fact, so strong that it has led to an exploding trade and current account deficit. In turn, these growing deficits have greased the world with liquidity and boosted economic growth rates through capital spending and industrial production, particularly in the Asian region.
An Asian consumption boom has followed, driven largely by employment gains, huge productivity improvements in China, and declining prices for manufactured goods, which significantly enlarged their market potential. A consequence of this boom in the Asian economies - and, in particular, in the Chinese economy - has been a significant increase in the demand for commodities, which has lifted the economies of Latin America, Africa, the Middle East, and the former Soviet Union.
At the same time, Europe has experienced an export-led recovery, driven by the emerging world, and Japan, also partly driven by exports, has begun to grow once again.
I admit that the above historical perspective is simplistic, but my point is that, today, we can say that - at least from an economic perspective - "this time is different". It is a fact that we are truly in the midst of an unprecedented global synchronized expansion. And not only that!
The expansion is reaching just about every corner of the world and almost every sector of its economy - admittedly, however, at different intensities. Still, as I have repeatedly pointed out in earlier reports, the current global economic boom is characterised by huge and growing imbalances. Steve Roach believes that these imbalances can be solved benignly, but I believe there will be some serious rebalancing consequences.
Are Financial Assets the First Victims of the Current Economic Boom?
It is important to understand that even when central banks expand liquidity at an ever-increasing pace (Weimar hyperinflation, Latin America in the 1980s, Zimbabwe now), liquidity does tighten temporarily from time to time, as price and wage increases outpace money supply increases. So, whereas the German stock price index rose in paper marks from 100 in 1913 to 26 trillion in 1923, there were 20% short-term corrections (lasting usually just two months) in 1920, 1921, and 1922, and a 25% correction in 1923 (in US dollars).
(However, the index fell from 100 to a low of 2.72 in 1922, before recovering to 26.80 in December 1923.) As GaveKal Research pointed out (see above), in order to sustain a bull market in asset prices, an everincreasing pool of liquidity is required and this is, in the short run, impossible for a central bank to achieve - even if its intentions are "to print money". In the example of the Middle Eastern stock markets referred to above, the prime drivers of liquidity are obviously oil production and oil prices.
From Figure 4, we can see that between 2002 and 2005, oil production soared from 25 million barrels a day to around 31 million barrels. The increase in production was accompanied by strong price increases. (Crude oil prices rose from $19 a barrel to $70.) However, at the end of 2005, oil production began to decline moderately and oil prices no longer rose. So, whereas liquidity was still plentiful, the rate of increase declined and led to a relative tightening of monetary conditions, which I suppose explains the dismal performance of the Middle Eastern stock markets over the last six months.
Aside from the Middle East, it is apparent that liquidity conditions around the world, while still expansionary, are less expansionary than in the 1999-2005 time frame. (Remember that it is the rate of change that matters the most.) From Figure 7, courtesy of Ed Yardeni, we can see that while bond yields are still below nominal GDP growth, they are no longer declining relative to nominal GDP growth, as they did between 2001 and 2004. So, we could argue that while an absolute tightening has not yet taken place, a relative tightening has been in force for the last 12 to 18 months. This would also seem to be confirmed by two other monetary indicators.
While Foreign Official Dollar Reserves are still expanding at an annual rate of 15% (no absolute tightening here), they are no longer increasing at an accelerating rate such as was the case between 2002 and 2005 - hence, a relative tightening is under way.
Now, whenever central banks create excess liquidity, symptoms of inflation will show up somewhere. Sometimes wages and consumer prices will react the most to expansionary monetary policies (for example, the 1960s and 1970s), but in today's world where, given the low wages in China and India, an almost unlimited labour arbitrage can take place, easy monetary policies drive asset prices such as homes, commodities, equities, art, and so on, higher, while wages and consumer prices rise only with a lengthy time lag (once commodity prices begin to be passed on in the prices of finished manufactured goods).
Therefore, it should come as no surprise that, when liquidity growth is slowing down, asset prices begin to cave in first. This is especially true of equities, since the stock market discounts economic events well ahead of time. In this respect, it is interesting to note that while home prices in the US have continued to rise nationwide, homebuilding shares peaked out in the summer of 2005.
Since I wrote extensively about the homebuilding industry last year, I shall refrain from making additional negative comments here, except to say that conditions have since deteriorated badly, with the number of total single-family homes available for sale (existing and new single-family homes) rising to a record high (see Figure 12, courtesy of David Rosenberg and Richard Bernstein). At the same time, the Home Buying Intentions Index is at its lowest level since 1991. I might add that when homebuilding shares peaked in the summer of 2005, analysts remained very positive on this sector.
But, as I have repeatedly pointed out, it usually pays to listen to the market. And in this respect, we should take rather seriously the sharp break in equity and commodity prices, as well as in some of the emerging market currencies, that we experienced in the second half of May. The break may prove to be only of very brief duration with new highs to follow, but the impulsive nature of the break suggests differently - at least for now.
Naturally, investors will immediately ask why stocks and commodities should sell off when we are in the midst of a global synchronised economic expansion, when corporate profits are still expanding. The point is that, precisely because we are in a global boom, liquidity is likely to become tighter for a while and that, as just outlined, in such an environment equities and other asset prices are vulnerable until liquidity conditions improve once again.
Another reason for the sell-off could be accelerating inflation, about which we have frequently commented in recent reports and which may have a very negative impact on discretionary spending and corporate profitability, and could even lead to a global recession with some time lag. I hope that our readers will have noticed that their cost of living is not currently rising by "core inflation" but by between 5% and 6% per annum. (The US Cleveland Fed Median CPI rose in April at an annual rate of close to 6%.) Other reasons for the sudden decline in equities could be the threat of a pandemic or geopolitical tensions, which could lead, if not to a military conflict, then possibly to a trade war or competitive devaluations. It is important for investors to understand that when markets begin to move sharply in the opposite direction of the prevailing trend - that is, from down to up or from up to down, as was the case just recently - the reason for the trend reversal is usually not known for quite some time.
But a well-established fact is that equity bull markets get under way amidst dismal economic and financial conditions, while bear markets begin when everything looks at its brightest, such as was recently the case (at least superficially). Moreover, the more speculation there was in a market, the more likely it is that the correction could be serious and take the proportions of a bear market (down 20-40% or more).
Near - and Longer-Term Considerations
I have to confess that I did hesitate for a long time before deciding to commit to paper the following observations, as they will undoubtedly cause some confusion, given the views I have expressed in earlier reports. However, there are times when, within a long-term view, short-term considerations become more significant. From a longer-term perspective, I still maintain that central banks - especially the US Federal Reserve - will have no other option than to print money and that, therefore, in the long run, asset prices will continue to increase - at least in nominal terms.
US MZM has soared as a percentage of GDP in recent years and, as in the case of Japan, has created a huge monetary overhang. And while monetary conditions have tightened relatively in both Japan and the US, because money supply is no longer expanding as a percentage of GDP, looking at credit growth there can be no question that monetary polices are still expansionary. I am grateful to Kurt Richebächer for having recently pointed out that, in the US, in the fourth quarter of 2005, non-financial credit expanded at a new annual record rate of US$2,445.7 billion.
According to Richebächer, this compares with US$1,710.5 billion in the second quarter of 2004, at the end of which the Fed started its rate hikes. Financial credit increased US$1,224.4 billion, as against US$932.7 billion in the second quarter of 2004. In aggregate, overall financial and non-financial credit growth accelerated over this period of rate hikes from US$2,643.2 billion in the second quarter of 2004 to US$3,670.1 billion in the fourth quarter of 2005. In percentage terms, borrowing and lending increased a staggering 38.9%.
According to Richebächer, "the fact to see is that all the rate hikes were undertaken in [the] complete absence of any monetary tightening. Plainly, the Fed has readily provided any bank reserves that the financial system has needed to maintain its credit expansion. It is a farce of monetary tightening. For all of 2005, total credit expanded by $3,340 trillion, to $40,230 trillion, up more than $500 billion from 2004's record $2,818 trillion increase. For comparison, annual total credit growth averaged $1,237 trillion during the 1990s. Trying to capture the dynamics, we compare the credit expansion with the simultaneous increase in real and nominal GDP. Well, in real terms, it was up $378.9 billion in 2005, and in current dollars, 751.4 billion."
So, in order to generate nominal GDP growth of US$751 billion, in 2005, total credit market debt had to increase by US$3,340 trillion - 4.4 times faster than GDP. Now, as is the case for the current account deficit, which hovers around 7% of GDP at present, the optimists will say that debt growth that is four times larger than GDP growth is sustainable. This may be the case for now, but the point is that, in the 1950s and 1960s, debt and GDP grew at about the same rate, with the result that in 1980, when Paul Volcker tightened meaningfully, total credit market debt was "only" about 130% of GDP.
Then, in the 1980s, debt grew at about two-and-a-half times GDP, in the 1990s at about three times GDP, and now at more than four times. In other words, as GaveKal Research pointed out, in order to sustain the asset bull markets and the economic expansion, debt growth will have to accelerate soon to initially five times GDP, later to six times, and if we extrapolate the trend that has prevailed since the 1960s, eventually to more than 20 times GDP.
Similarly, the current account deficit, which grew from 2% of GDP in 1998 to around 7% of GDP, would have to triple to around 20% of GDP in the next five to seven years in order to sustain the growth rates in foreign official dollar reserves (global liquidity) and economic growth around the world, if the recent trend is extrapolated. Also not forgotten is the US saving rate, which declined from an average of 9% in the 1970s to less than zero at present and turbo- charged the economy. If the stimulative economic impact of a declining saving rate is to be maintained, the saving rate will eventually have to be at around -10%.
Now, you don't need to be an economist with a Harvard education to see that these trends are not sustainable in the long run. However, it is my belief that the Fed, and other central banks which are at least as agile at printing money as the Fed is, will try to postpone the hour of truth by a renewed massive liquidity injection when the next recession arrives. So, my concern remains the same: before the final debt crisis hits, we might see very high rates of inflation - most likely hyperinflation, with all asset and consumer prices soaring (amidst falling real incomes).
July 7, 2006
by Marc Faber
Chiangmai, Thailand
Corrections or Bear Markets in Asset Prices, Part II
YESTERDAY'S EDITION is a long-term forecast. Near term, I envision a scenario whereby credit growth slows down and the economy moves into either a very low-growth or recessionary phase.
Why? Since US debt growth has driven asset prices higher in the last few years and allowed US households to extract funds from their assets in order to sustain increasing consumption, it is likely that home and stock prices, which will no longer rise and more likely may go down, will have a pronounced impact on economic growth rates. In this respect, it is important to understand the following. While the Fed fund rate has increased from 1% in June 2004 to 5% at present, lending standards in the housing industry have continued to decline.
This was one reason why debt growth has accelerated since the second quarter of 2004, as Kurt Richebächer demonstrated above. In fact, Bridgewater Associates produced recently a very telling figure showing what has been happening in the housing industry since 2002. Mortgage borrowings have begun to rise at a much faster clip than residential construction (see Figure 15). (I am sure the optimists will think that this trend is also sustainable.)
As Jason Rotenberg of Bridgewater Associates points out, the difference between mortgage borrowing and residential construction is the "largest ever" and shows by "how much housing has added to growth in recent years through mortgage borrowing (with over a third of that money flowing to non-housing spending) and construction".
Now, here is the bad news. First, the dismal performance of homebuilding shares since last summer, given their low valuations, seems to indicate that conditions in the housing market are likely to be far worse than the official statistics suggest. Two, as Bill King pointed out in one of his recent daily missives, and quoting the Chicago Tribune , mortgage defaults are on the rise.
According to the Tribune , "In Illinois during the first three months of 2006 nearly 13,700 properties entered foreclosure, up 32% from the fourth quarter of 2005, according to an analysis by property tracker RealtyTrac Inc. The numbers are grimmer elsewhere in the Midwest. Michigan and Ohio, battered by automotive-related job losses, together recorded 45,000 mortgages entering some stage of foreclosure in the first quarter.
Those are increases of 91% and 39%, respectively, compared with last year's fourth quarter. Nationally, foreclosures are up 38%, higher than in any quarter of last year, RealtyTrac said... 'The increases we've been seeing in foreclosures don't even reflect the worst-case scenario that could happen when the $2.7 trillion in adjustable-rate mortgages are reset over the next 18 months' said Rick Sharga, vice president of marketing at RealtyTrac" (emphasis added).
No matter how optimistic (or desperate) bank and sub-prime lending officers might be, I suppose that, at some point, even these optimistic folks will do the totally unthinkable and tighten lending standards somewhat, as they did in the early 1990s. Also, given the high level of adjustable-rate mortgages that will be reset in the next 18 months, it is difficult to see how much tighter the Fed can become!
Nevertheless, housing, the most significant driver of the economy in this expansionary phase that began in November 2001, is unlikely to provide much economic stimulus in future. Granted, some observers will contend that a housing slowdown will be offset by an increase in salaries and wages, but such an increase would also lead to higher inflation and make it next to impossible for the Fed to cut interest rates.
In short, whereas I do expect central banks to embark anew on massive "money printing" in future, and to flood the system with even greater liquidity injection than they have done since 2001, for the next three to six months or so, global liquidity may not rise sufficiently to keep the global economy on its growth trajectory and asset prices from declining.
An Attempt to Structure a Shorter Term Investment Strategy
My readers will know from past reports that I am a firm believer that central banks will print money to save the system from imploding under the ever-increasing economic and financial imbalances. Therefore, under a money-printing regime, the Dow can easily rise over the next six to ten years to 33,000, while it loses value in real terms (that is, against gold - with the result that sometime in the future one Dow Jones Industrial Average will only buy five ounces of gold or less).
Obviously, under these conditions, the US dollar will also lose value against gold and against the currencies of countries that are endowed with a more responsible central bank (Switzerland - I hope...) or which are economically far more competitive than the US (China). Needless to say, in a money-printing environment, 30-year US government bonds will be one of the worst possible investments. But, this is all in the long term. For the next six months or so I envision the following.
Equities around the world will weaken further and US home prices will decline. US consumption will slow down or could even temporarily decline, as consumer sentiment turns decidedly down and leads to an increase in the saving rate. Corporate profits will begin to disappoint badly as the huge financial gains that boosted profits in the last four years no longer grow, or decline.
As a result of a US consumption slowdown, the US current account deficit, which flooded the world with liquidity, will no longer expand at the same rate as between 1998 and 2005 (or possibly even may contract temporarily), thus withdrawing an important source of liquidity to the world. Foreign economies will slow down or run into some problems as industrial commodity prices sell off, or no longer increase. This will add to a "relative" tightening of monetary conditions. (Remember what happened to the Middle Eastern stock markets.)
In asset classes jargon, the above scenario, which I expect to unfold over the next few months, would imply the following:
US bonds , an asset class about which most investors have been very negative recently, could rally somewhat, as economic news begins to disappoint and as there is a modest flight to safety. In addition, portfolio managers and the asset allocation crowd (or momentum players) who successfully rode the 2002-2006 bull market in global equities and achieved total returns in excess of 100%, may opt to raise some cash and shift from equities into short-term bonds.
The US dollar could benefit from a reduction of risk appetite among the investment community, as the money that chased high yields and high returns in countries such as Brazil, Indonesia, Turkey, and India, to mention a few markets, is repatriated. I have to admit that this is a low-confidence forecast, since a weaker economy in the US could also adversely affect the US dollar. (In addition, I would expect the US dollar index eventually to break down below its support around 80.)
US equities have broken down from a rising wedge with heavy volume and with significant momentum (see Figure 18). The technical implications are usually bearish and further downside risk exists. Also, as can be seen from Figure 18, huge overhead resistance now exists for the S&P 500 between 1280 and 1325. As I pointed out in the April report, entitled, "A Simpleton's Guide to Economics and Investment Markets", the Dow Jones seems to have traced out a "three peaks and the domed house" formation from where a significant decline usually follows. In addition, the "Hindenburg omen" gave several sell signals in late April.
Sell signals do occur when unusually large numbers of stocks both reached one-year highs and lows but prices continue to climb. The Hindenburg omen sell signals occur only seldom. They indicate a highly unstable stock market. Whereas their record is not perfect, Hindenburg omen sell signals preceded the crash of October 1987, the Long-Term Capital Management collapse of 1998, and the bursting of the "Internet bubble" in 2000.
Emerging market equities , which were not only the crowd trade of 2005 and early 2006 but which also became extremely overextended, are among the most vulnerable asset classes over the next few months. The Istanbul Stock Exchange National 100 Index dropped in a few days by 25%, while Russia, India, and Brazil were off by about 20% (see Figures 19 and 5). I should like to remind our readers that no matter how favourable the fundamentals of an economy appear to be, equity markets can be totally out of step with the economy - as was the case for Chinese equities between 2002 and 2005 when they fell by 50%.
Emerging economies' currencies have also suddenly begun to weaken. The Turkish Lira lost 15% within just a few days, and the Brazilian Real fell by an almost equal amount. Currency weakness and slumping stock prices led to a double whammy for investors in these countries. Some readers may wonder what caused these emerging economies' currencies to suddenly weaken. In Latin America, a populist socialist move is well under way, and in many other emerging economies the domestic price level has increased very significantly in the last few years. In the case of Thailand, my impression would be that prices have increased by about 50% over the last four years - admittedly, from an extremely low level. Another reason for currency weakness among emerging economies may have to do with the "flight to safety" referred to above, and with an impending decline in commodity prices.
Industrial commodities are vulnerable to a global economic slowdown. Granted, we are in an environment where almost all economies of the world are expanding, but this is the situation today, now! Driven by declining asset prices, the global economy could slow down abruptly and lead to temporary disappointing demand for industrial commodities. At the risk once again of being wrong, I still believe that copper prices have a significant downside risk (see Figure 21). Gold prices could come under further pressure, but the monetary aspect of gold should probably lead to an outperformance of gold compared to industrial commodities whose prices depend on global economic growth. Still further weakness to below US$600 per ounce wouldn't surprise me. Among the commodities, complex agricultural commodities may entail the lowest risk. However, when asset markets come under pressure, all assets can suffer - though obviously to varying degrees. In this respect, I would avoid the purchase of the overhyped and momentum-driven ethanol stocks for now.
Residential real estate , especially in the high-end condominium market, also appears to have considerable downside risk. Compared to a few years ago, during my travels I am now seeing a surprising number of cranes building trophy condos in urban centres all over the world, as well as trophy second homes in resort areas. When the Asian crisis occurred in 1997, it hit well-to-do people the hardest (the leveraged large asset holders). Now, looking at the immense profits the "money" and other "asset shufflers" such as real estate speculators and private equity managers have achieved (not to mention the CEOs), I wouldn't be surprised if, for a while at least, a payback time dawns upon the financial industry and the (in my opinion) overpaid CEOs. A good contrary indicator may be The Economist's April 29 - May 5, 2006 issue, which had on its cover: "On top of the world - Goldman Sachs and the culture of risk". It is worth noting that Goldman Sachs' shares topped out in a most timely fashion on April 20 and formed a "head and shoulders" between early April and mid-May.
Furthermore, I was pleased to read that, last year, some of my friends earned in excess of US$500 million. (According to the Financial Times of May 26, 2006, the top 26 hedge fund managers earned US$363 million, on average, in 2005.) As I indicated in earlier reports, whenever there is a concentration of earnings in one sector of the economy - in this case, among us "money shufflers" - and our great achievements make headlines in the media, the end is near for that sector!
(I would be surprised if there were any fund or hedge fund managers in the 1970s who earned more than US$10 million per annum - another sign of how money has lost its purchasing power - read "inflation".) Of course, there is hope for our financial nirvana: Mr. Bush just appointed Henry (Hank) Paulson, former CEO of Goldman Sachs, as US Treasury Secretary. And guess whose interest he is more likely to protect? The common man, the workers, the middle class - or his buddies on Wall Street?
So, I am looking forward to the time when my friends among the top hedge fund managers will - thanks to another "money printer" in the current US administration, a group of politicians whose superior intellectual capital far outweighs the negative impact of the US current account deficit - earn a trillion dollars each. (By then, an ounce of gold will probably sell for around US$1 billion, while billionaires will be about as common as millionaires are today.)
But, let us hope for now that the market's reaction to the appointment of Mr. Paulson won't be as negative as it was following the appointment of the chief money printer to the Fed, when both bonds and the dollar subsequently tanked.
In any event, for now, as outlined above, I see some dark clouds hanging over the financial and luxury goods sector, including the art, collectibles, and trophy wife market.
Regards,
Marc Faber
).
