Sohail Rabbani June 11, 2003

Tags: Trade , Economy , Technology , Business

href="/tag/Chowk">Chowk FOMC is back in session trying to make sense out of the chaos. We have much to catch up to so we begin afresh.)

The Good, the Bad, and the Ugly

We keep hearing from reliable people who watch daily television, read regular newspapers and get around public places that everyone in the mainstream media is convinced of an ongoing economic recovery, even an impending boom as well as a new bull market in stocks. We beg to disagree.

Here at the Chowk FOMC we do not follow CNBC / CNN nor do we read the mainstream press, nor have we been going out much lately. Nonetheless, sifting through our materials we see an economic picture that is not as rosy as officialdom would have us believe. When we compare our own conclusions to those of the mainstream financial media, government officials and Wall Street cheerleaders, it seems to us that we may just as well be looking at different planets.

During our recent sabbatical we saw all manner of experts make exuberant forecasts for 2003 and beyond.

Unlike optimistic yearly forecasts of the pundits assembled by the likes of Businessweek and Barrons, we believe that 2003 should turn out to be the fourth consecutive down year for the U.S. equity markets (in global terms). But now is not the time to go into too many details. Today, we will only briefly glance over gold, the dollar, and the stock market. Those are the Good, the Bad, and the Ugly, respectively.


The Good (gold)

To ignore gold is to negate 2,500 years of financial history. Gold is the oldest and purest form of money. It is a form of money that is no one else’s liability. It is ‘natural’ money in the sense that governments cannot create it at will as they can paper money. Governments have always tried to control money and therefore, from time to time, banished gold from their realms or made its possession illegal. Yet, such is the power of gold in human civilization that no government in history has been successful in abolishing it.

Gold has entered a long-term bull market and in time we should see another gold rush. After three decade of fiat money reign and despite efforts by governments and bankers to discredit the yellow metal as an “ancient barbaric relic” that has no place in modern financial systems, gold has survived and is returning to reclaim its power and prestige. After 22 year of silence in the financial doghouse the yellow dog is barking again. Gold is coming back in fashion.

As of June 1, 2003, over a billion Chinese have been legally allowed to buy, sell and own gold without any government interference. In Chinese culture gold has always had a place of prestige as it does in many Asian societies. The Shanghai gold exchange is up and running and before long demand should exceed all expectations. The rapidly increasing size and purchasing power of the middle class in India should give a further boost to worldwide demand as Indian culture also traditionally values gold. In Australia an exchange traded fund based on physical gold bullion deposits was inaugurated in March 2003. In the first three month since its initial public offering volume has increased about 500%. In the U.S., the Gold Council is launching a similar product, an exchange traded fund with the symbol GLD, to be listed on the N.Y. Stock Exchange upon final SEC approval which is presently underway. We shall not belabor the point any further but the foregoing reasons may suggest to the reader that the worldwide demand for the yellow metal should be on the rise.

It is also noteworthy that some substantial proportion of the gold reserves of world’s central banks are not physically present in their vaults. The genius bureaucrats who run central banks thought of a way to earn interest on gold assets without having to sell them. Though still listed as assets on the books, they have been physically “loaned” out. The “bullion banks” who “borrowed” that gold at 1% sold it to gold producers and invested the proceeds in bonds with higher yields. The producers bought the gold because it was easier than digging it up from their mines. The producers mortgaged the “future production” of the mines (i.e., underground oar) to raise the funds. Their customers didn’t care where the gold came from. Mines stated closing down, miners lost jobs, annual production kept falling.

This caper went on for 22 years as the gold price remained in the doldrums. In 2001 – 2002 the trend reversed as gold price bottomed out. World wide gold “loans” outstanding, which if called would require physical delivery, exceed present annual production by some significant factor. The lowest estimates put total gold “short interest” at two years’ production, highest estimates are above fifteen years. Be that as it may, the effect on price should be upward pressure.

Being mindful of space limitations, today we only wish to leave the reader with one final thought about gold.

We firmly believe that one day, and that day may arrive sooner than any one imagines, we should see that the price (in U.S. dollars) of an ounce of gold and the S&P 500 Index are the same number. We shall go a step further and add that we should also see the day, in the not very distant future, when one ounce of gold is worth a unit of the Dow Jones Industrials. Today one Dow unit can buy 24 ounces. In 1999 one Dow unit bought 42 ounces. The reader may think that we have taken leave of our senses and have become delusional to make such a suggestion. It has happened a few times before, most recently in 1979-1980. We shall stubbornly stand our ground.

Gold, oil, grain, meat and other natural resources should outperform all paper assets for the next few years, not only in the U.S. but around the world.


The Bad (U.S. Dollar)

“We are in a country that is buying more from the rest of the world than we’re selling, and we’re doing it on a big scale,” Warren Buffett said on May 21. “Any other country in the world that did that on that scale would have seen greater currency depreciation already,” Buffett went on. “We have such a strong currency historically that there’s been a delayed effect. But it’s started to happen in the last year, and unless the underlying conditions change, it’s going to continue.”

Over the next few years the U.S. Dollar should continue to decline much more in value, thus further eroding the equity and debt markets in its wake. To those who give us the story that a cheaper dollar is good for American exports and thus for correcting the trade balance, we ask to look at the trade balance with Japan. Since 1985 the Dollar has gone from about 250 Yen to about 120 Yen today, yet the trade balance with Japan is not any better. The total US current account deficit (which is mostly trade deficit) in 2002 was over $500 billion. That is 5% of GDP. By 2004 it is estimated to approach 8%.

We do not believe in the dreaded arrival of deflation any more than we believe in the coming of Wee Willie Winkey. That seems to us as a ploy in order to justify inflationary policies. It’s the classic ‘bate and switch’ that tricksters employ. Milton Freedman, von Miese and Keynes all agree (a rarity in itself) that deflation is a monetary phenomenon primarily, if not exclusively. Consider then, the speed with which money is being “created out-of-thin-air” as it were. For three months ending April, 2003, the annualized growth rate of money supply were: Currency notes = 7.3%, M-1 = 8.3%, M-2 = 6.9%, commercial bank credit (April) = 9.6%, finance company credit (Feb) = 9.6% and Federal Reserve Bank credit = 11.2%. All this in an economy with approximately 2.5% GDP growth!!! Curious minds wonder?

The yield curve, over time, should get steeper (Sir Alan Prints-a-Lot’s brazen interventions notwithstanding) as long term interest rates sneak up in response to the swelling money supply, falling dollar and skyrocketing debt levels that go beyond all historic records (Yes, we are long-term bearish on bonds also but we dare not short them, not yet any way. When the bond market does collapse, as collapse it must one day, the fall should be swift and spectacular).

The critical reader might say that increased money supply by itself does not inflation make. That it depends on the interplay between the velocity of money and absolute money supply. (Money velocity, roughly speaking, is the measure of the frequency of transactions by which money recycles through the economy. Velocity, of course, is the twin sister of demand. Unfortunately, the Greenspan Fed stopped publishing velocity figures a while back.) The reader may cite the example of Japan where the central bank has the money spigot open even wider than the US Fed (if that can be imagined) without palpable inflationary effect and despite all that real deflation has materialized. (e.g., Real estate prices in Tokyo have gone down every year for the past nine years and are presently 70% lower than they were at their peak in 1989-90.) People are not borrowing and spending in Japan (at last count prices fell 3.5% year-over-year). The Japanese are still saving, bank loans are shrinking even though the cost of financing is almost nonexistent. And thus mountains of Yen are piling up in the system. The peculiar thing about central bank created credit, or liquidity, as Sir Alan likes to call it, is that until people draws upon their credit lines, the “created” money does not really “exist” in the economy. And this brings us into the murky area of human behavior and psychology. In the interest of brevity we shall not go there today.

In response we shall concede to our critical reader that deflation may thus be a possibility, albeit only a theoretical one. The existing realities on the ground, not the least of which are the ‘cultural differences’ between US and Japan and assorted other facts simply do not lead us to that conclusion. Therefore we are on the look out for inflation.



The Ugly (stock market)

JP Morgan Chase global equity strategist Abhijit Chakrabortti, among many others, believes that the October, 2002, low was the bottom of the bear market and he recommends buying U.S. stocks. He has raised his year-end target for the S&P 500 index, from 1,010 to 1,050. Surely, Mr. Chakrabortti must know what he is talking about, but his arguments fail to convince us. He spits off several ‘reasons’ for buying. He claims that there is no more inventory to write down; corporate profits are rebounding significantly; restructuring has been intense; productivity is growing strongly; and the oil price and dollar have weakened. “The impact on earnings is incredibly positive,” he notes. The glass is half full, according to him. But alas it is not, we regret to say. If the glass were even at the half mark we would believe him.

We emphatically reject this wishful notion that the October, 2002, lows were the bottom for the popular stock index prices. While we think that the final ‘rock bottom’ of this secular bear market is years away, 2003 could well be a ‘reprieve year’ for Wall Street in the downturn that began in 2000 (actually it began in 1999, only it didn’t become obvious until 2000, but that’s a totally different debate).

By ‘reprieve year’ we mean that it is conceivable that on December 31, the Dow, the S&P and the Nasdaq post nominally higher prices than they did on January First (we shall not bet the barn yard on it though). If that happens to be the case, it could still be an illusory gain because the U.S. Dollar may have lost so much value by then that any gain in the nominal points may not be enough to compensate for it.

In today’s global marketplace absolute returns on investment based on a market benchmark’s performance should not just be measured in the local currency. They should be evaluated, in global terms, by using a ‘basket of currencies,’ or some other ‘Purchasing Power Parity equivalent’ as the criteria.

For illustration let’s take the example of Argentina. In November 2001 the Argentinean Merval Index posted its lowest price, in local currency terms, and then proceeded to go up 50% by June 2002. However, in the mean time the peso had tumbled in value so far that, if viewed from abroad, in U.S. Dollar terms, the Merval Index actually bottomed out in June 2002. (BTW, Argentina’s stock market is the third best performer – after Kuwait and Latvia – so far this year, in U.S. Dollar terms.)

Likewise, the S&P 500 closed at 768.67 in October, 2002, it’s lowest (so far) since the Great Mania days. But that is only in U. S. Dollar terms. If we were to measure it in Euro terms, as all the European investors must do, then the S&P hit yet another new low during its recent nose dive in March, 2003. The U.S. Dollar had declined by 11% between October 2002 and March 2003 and that is what made the March low even lower than the October low. Of course, they will never talk about this on Bubblevision (aka CNBC), but if we were to use any of the other English speaking peoples’ currencies (Loonie, Kiwi, Aussie, Quid) we would get very similar results. We arbitrarily picked the English speakers’ money because by our imagination they would be the ones to observe the U.S. more intently than non-English speakers. We are similarly quite sure, though we didn’t bother to do the math, that looking at the S&P500 in terms of Swiss, Danish, Czech, Hungarian, Brazilian (yes, even the real is beating the greenback), South African and assorted other free floating currencies one would find the same relationship between the October 2002 lows and the March 2003 lower lows. By this global measure the lowest low so far was March 12, 2003 and not October 9, 2002.

If we look at the Dow Jones Industrial Average the picture is even worse. The Dow thirty represent at least 25% of the entire U.S. market capitalization. In the past year or so the various peaks of the Dow are as following:

March 19, 2002 = 10,635.25
May 17, 2002 = 10,353.08
August 22, 2002 = 9,053.64
November 28, 2002 = 8,931.68
January 14, 2003 = 8,842.62

After that came the real bottom (so far) on March 12, and then another round of feeding frenzy began that peaked on March 21, at 8521.97, after which prices pulled back.

Ironically, on April Fool’s day, the present mini-mania began which continues at the time of this writing (June 5, 2003). And we are being told that the party is on, happy days are back. The lemmings are jumping in head first and the temperature is up.

It is instructive to glance at the previous bear markets. U.S. in 1929-1932 and Japan 1989 – present are the two most recent examples that come closest in magnitude.

After the crash of 1929, the Dow Industrials did not advance above its peak until the 1953. And if we adjust for inflation it was 1962 before the Dow broke its 1929 level. People who bought at the peak in 1929 had to wait 33 years before they broke even in real terms. That is real “buy and hold.”

In Japan, the Nikkei topped out towards the end of 1989 at about 39,000 and last month it made a new low of around 7,700. During the intervening years there have been many sharp price hikes a couple of which took the Nikkei up by more than 50%. Coincidentally, after almost exactly three year following the peak, i.e., about the same time lapse as the present is from the March 2000 peak in the U.S., the Japanese market staged a most spectacular rally that lasted for several months and took the Nikkei vertically up smashing all the “resistance levels” and “moving averages” that the Bubblevision crowd holds so dear to their hearts.

Here we would like to say a word or two about corporate insiders (i.e., officers, directors and major stockholders). Over the recent months corporate insiders have been selling their own stock and the rate of those sales is becoming frantic. Particularly, April and May 2003, have been record months. Even Steve Ballmer, Microsoft’s CEO, has sold 13 million shares recently. Ballmer, unlike most others never sold any of his stock in twelve years. Also, Margaret Whitman, CEO of eBay, has sold almost 17% of her total stock holdings only since March, 2003. These examples can go on and on. The SEC makes these figures public. We encourage prospective buyers to check them out. A prudent investor would be very skeptical of any stock that insiders prefer to dump by the carload, no matter what the sales pitch.

Corporate America is in a huge mess and profits have collapsed. From the third quarter of 2000 (3Q’00) until the forth quarter of 2002 (4Q’02) profits fell 28.6% and if measured from their peak in 1997 the profit decline has been 36.4%. This is the steepest fall in the entire postwar history. In the same period, i.e., 3Q’00 – 4Q’02, business fixed investment in non-financial sector declined by 12.9% ($165.9 billion) while at the same time consumer spending went up 7.8% ($681.7 billion). So while the gross GDP figures show an expansion in the economy, production suffered while consumption flourished. This is not necessarily good because it is the kind of growth that isn’t self sustaining.

Net investment is what generates long term profits without creating immediate expense since it is capitalized on the balance sheet and begins generating immediate revenues for the manufacturer of capital goods. But if net investment is absent and depreciation changes continue a profit squeeze will inevitably follow. In 2001-2002 net fixed investment for S&P 500 fell form $407.3 billion to $268.1 billion, year-on-year.

Pension fund shortfalls are another huge issue across the board. It is estimated that the shortfall for S&P 500 is over $300 billion in 2003. To borrow a sound-byte from Mr. Chakrabortti, “The impact on earnings is incredibly” -- negative.

The principal force that presently levitates the stock market is that there is a mad rush by mangers to toss other people’s money at the race track of Wall Street. These people have no incentive to be prudent with the clients’ funds. They are never penalized for losing money as long as the benchmark indices also lose. They only get fired if they miss out on a upside opportunity. This creates a mentality of lemmings.

These are the same people who, for the last three years, have been telling the gullible public that happy days are around the corner. We urge the reader to explore the archives of the Wall Street Journal and see first hand what rubbish these so-called professionals have been talking about. Unfortunately, the devil is in the details and in today’s 30-second sound-bite culture no one has time for details.

Space constraints prevent us from going into minute details so that we may individually debunk Mr. Chakrabortti’s “reasons” for buying stocks today (optimal inventory, profits rebound, restructuring, productivity, oil price and dollar). Lest we should induce our reader to sleep from sheer boredom, suffice it to say that in our view each of those bullish claims is built on dubious grounds.

We have often been reminded that valuations and fundamentals do not have any bearing on the near-term price fluctuations of a stock or a commodity. Near-term price fluctuation is the manifestation of the cacophony of the perceptions and emotions (greed, fear, hope & faith) of all the market participants. It’s a live auction and adrenaline is flowing. A short-term trader is just playing a guessing game trying to figuer out what all the other guessers are guessing. Therefore, no one should be right, on the average, more than half the time. Winning or losing, over time, strictly depends on a disciplined approach towards loss control. We always tell our friends that a normal person, with a regular day job, must never attempt to play this dangerous game. This is not what we call investment. It is pure speculation and is best left to those who live and die by it. The rules of investment are entirely different. Long term investments must only be made on the basis of value and fundamentals after due diligence.

The above mentioned arguments, we hope, will give the bullish reader some food for thought and perhaps induce him to caution and skepticism.

Ordinarily, we try to discourage people from even making long-term investments in the stock market. In our humble opinion the stock market is, in a manner of speaking, legally organized theft. The average person usually loses. Investment in tangible assets is what we always recommend our dear ones to make. But alas, the public is hooked on stocks and they insist on participation. So, if one must buy at all, at present, we suggest only natural resource based companies or dividend paying utilities.

There is still way too much speculation and wishful thinking going on. To those who have bought into the present day hype of an impending bull market we urge great caution, particularly against bubbly technology stocks. We ask the bullish reader to review some history and exercise patience until real bargains come on the auction block. Trust us, dear reader, one day there should be really valuable bargains in the stock market but today is not that day. However, if history is any guide, that is going to be at a time when people are demoralized and pessimistic and no one even wants to talk about stocks. Price to earning ratios, price to book, price to sales should all be below their historic mean and average dividend yields should be between 5 to 6%.

(P/E for S&P 500 is presently near 35, and dividend yield under 1.8%, the historic norm for the S&P 500’s P/E is about 15. This calculation is arrived at by using Standard & Poor’s “core earnings” and not the bogus “pro-forma” or “EBTIDA” nonsense which the Wall Street hustlers use to arrive at the commonly cited P/E near 20 for the S&P 500.)

Whether our prognostications come true or not, only time will tell. We don’t know what will happen in the future, we only say what should happen.

These are not predictions for we possess no crystal ball. These are our ‘informed prejudices’ upon which we form our view of the world. These are our own opinions and we are sticking to them.


(In the interest of a smooth flow of narrative and space considerations we have not attributed sources in the body of text unless it was a direct quote. All facts and figures are taken from reputable published sources and, upon request, we shall happily direct the reader to them. The sources used for this article are: Dr. Marc Faber, editor of the DBG Report; Richard Russell of the Dow Theory Letters, William Fleckenstein of Fleckenstein Capital; James Grant of Interest Rate Observer; Eric Fry of Apogee Research; Dr. Kurt Richebacher of the Richebacher Letters, John C. Doody of The Gold Stock Analyst; Financial Times, Yahoo Finance, MSN money central and Bloomberg.)

Disclosure: Of the items mentioned in the article, at the time of writing (June 5), the author had the following positions: Long: Gold, Crude Oil, Swiss Franc & Canadian Dollar. Short: US Dollar & eBay. Positions change frequently.