Wednesday, October 01, 2003
Bye-bye, Refi:
Housing activity will continue to falter in coming months as mortgage rates rise in tandem with the long bond's yield.
Speaking of the recent decimation of the bond market, it is curious that folks have chosen to view it as positive signs that the economy is recovering, rather than recognizing the intensely speculative nature of what has been happening so far. Bonds have risen considerably over the past 3 years due to aggressive interest rates cuts by the Federal Reserve, and especially since April 2003 when Alan Greenspan hinted that open market operations (including monetizing debt) might be initiated to keep long term interest rates low. When Greenspan dropped a MAJOR BOMBSHELL in July that such open market operations might no longer be needed, the bubble was burst. Now, rising long term interest rates will essentially stall the home refinancing movement and the property market that have so far helped to prop up the US economy, but so far this reality has been met with a great shrug by investment specialists. Capitol Commerce, a mortgage refinancing company has just shut its doors, after having had the busiest month of July for the past 17 years that it has been in business. There might be more horror stories lurking out there.
The G7 conference:
The recent G7 conference in Dubai is the major story for the month. First, there was the hint that major signatories of the 1999 Washington Accord (which restricts the sale of gold by central banks to around 400-500 tonnes each year) were pretty much in favour of renewing the accord next year, but with a certain gradual upward bias in gold sales targets. Gold commentators were dismayed, saying that this was a thinly-veiled threat once again by central bankers to manipulate the price of gold and keep it low, thus ensuring continued support and trust in fiat currencies (read: confetti currencies). The truth still remains however, that the continued support for the Accord is testimony to the fact that the world's central banks starting from this millennium no longer support blatant US anti-gold bias which has existed since the removal of the gold standard so many decades ago.
US Treasury Secretary John Snow tried to pressure the Chinese and Japanese to revalue their currencies upwards against the US dollar. The Chinese of course did not acquiese, but the Bank of Japan, knowing that it could not hold the forte any longer and that the Yen would rally anyway, did so. This probably accounted for the reaction on Wednesday 24 Sept displayed by the Nikkei_225, which was smashed 400+ points. A rising Yen against the greenback would mean that Japanese goods would become unattractive to US consumers, thus hurting Japanese exports to the US. This would threaten the Japanese economic recovery. What the US is trying to do is to control the massive size of its current trade deficit. It is now importing far more than it is exporting, and the cheaper foreign imports are now causing manufacturers in US to experience a drop in pricing power, leading to lower revenues and profitability. A cheaper US dollar versus Asian currencies would make imports more expensive, thus hopefully strengthening domestic demand and boosting domestic spending amongst US consumers.
Debt, debt and more debt
In connection with the Fed decision to keep interest rates at 1%, why does the Federal Reserve see disinflation or even deflation as their top concern? It can be summed up with one word: debt.
Household Sector Borrowing has risen from a low of around US$100 billion in June 1991 to an all-time high of around US$1 trillion in June 2003. Non-Financial Sector Borrowing has grown six times from its low in July 1991. Both Credit Market Debt and Mortgage Debt have doubled in the last 10 years. In short, there has been an explosion of consumer debt which has risen unabated despite the recent economic downturn or the supposed recovery. If interest rates were to increase, so would this debt burden, and so would bankruptcies.
Corporate debt, already at record highs, increased a further 1.4% in 2002 and at an average annual rate of 3.7% in the first quarter of 2003, to US$4.9 trillion. In a usual economic upturn, that borrowing would be channelled into productive things like capital spending and hiring workers. But not this time round. Capex and employment has remained anaemic. Instead, the rising corporate debt has been channelled into pumping up inventory and factory capacity even when end-demand is not in sight.
For the current fiscal year, the US national deficit will be more than US$400 billion, and could approach US$500 billion for fiscal year 2004 which starts on 1 October 2003. The US$5.6 trillion budget surplus that Americans anticiapted when the Bush administration took over has now turned into a US$5 trillion budget deficit, no doubt made worse by the three tax cuts. The current US national debt now stands at US$6.813 trillion, and this figure increases by roughly US$5 billion everyday. The national debt to GDP ratio is at an all time high of 350%. Current Social Security and Medicare trust fund surpluses are now being applied to the budget deficit. Those funds are supposed to be dedicated to pay future expenses. When these funds themselves turn to deficits, the Baby Boomers when they retire will find that all they have in their cookie jar is at best a deflated US dollar, or at worst, an IOU.
Of course, there is also the trade deficit, also known as the current account deficit, which widened to US$40.3 billion in July. Foreign investors are loaning roughly US$500 billion to the US every year. If they decide to slow down this funds transfer, then US stocks, US bonds and the US dollar will sink faster than a knife through hot butter. The US is borrowing a collosal amount to sustain the present economic growth at the expense of future growth.
Federal Reserve Board member Ben Bernanke has acknowledged the Fed's ability and willingness to turn on the "printing press" in order to avoid deflation, which is supposed to be the result of unsustainable debt, declining consumption, excess capacity and over-investment. But if the printing press were to be turned on full blast (which is basically the only way the federal government can weasel its way out of the monstrous debt burden), then run-away inflation might well occur. As I have never hesistated to point out, this would be bad for stocks, bad for bonds, bad for the US dollar, and good for gold and silver. This brings to mind the late 1970s when the rate of inflation shot past 10% and gold reached a grand US$850 per ounce. However, the fact remains that low interest rates are currently the only way to keep the massive debt boat afloat. Hence, the Fed has to do its part by weighing deflation as a heavier concern than inflation. QED.
Some crooks were spooked:
Earlier this month, New York Attorney General Eliot Spitzer announced the filing of a complaint against a New York-based hedge fund and four mutual fund companies alleging that they had engaged in illegal trading practices. The assertion was that Janus Capital Group, Strong Funds, Bank of America's Nation Funds, and Bank One allowed the hedge fund Canary Capital to profit unfairly in after-hours trading with the mutual funds. In return, Canary Capital carried out investments with some of the companies' other funds, generating sales and fees for the companies. Essentially the illegal trading was carried out in this way: Many companies release their earnings reports after 4pm when the NAV of the mutual funds has already been established and no further trading is allowed to investors. A favourable earnings surprise might cause the companies' shares to go up in value, thus making the mutual fund worth more. Canary Capital was allowed to buy into the mutual fund after trading hours based on the same NAV that was on the 4pm close. This allowed Canary Capital to profit unfairly from market sensitive information at the expense of existing mutual fund investors. Spitzer called this "betting on a horse after the race had been completed".
The complaint announced on Wednesday is the result of a 8-month long investigation by Spitzer's office. In settling the complaint, Canary Capital agreed to pay back US$30 million in illegal profits generated from the trading and a further US$10 million penalty. Canary neither denied nor admitted to the charges.
Now, hedge funds managers have a fiduciary duty to their rich and wealthy clients. What Canary Capital was doing was for the benefit of its shareholders and investors. Even though it was illegal, at least it was performing its duty profitably for the clients, and therefore its actions are in some way excusable.
But I can only have the utmost comtempt for the mutual funds, who are supposed to have a fiduciary duty to all the "mom-and-pop" investors who have entrusted their money to the funds. The mutual funds conspired with the big boys and cheated the ordinary investors of their rightful NAV. Their actions are as despicable as they are deplorable. Mutual fund were not created so that the big guys could take advantage of the little guys. They were not created so that the little guys could be shot at and stolen from routinely. I can only applaud Spitzer's investigation, and hope it leads to a better public understanding of the illegal manipulation and tape-painting that is currently an open-secret on Wall Street.
By the way, it is also an open-secret that mutual funds routinely engage in other practices that siphon shareholder value away from the "mom-and-pop" investors into the pockets of the traders and fund managers. Take the practice of soft-dollaring for instance. Normally, when large clients engage the trading services of brokerage houses, the brokers would give a discount on the brokerage fee in order to entice the clients to trade with them. However, many mutual funds allow the brokerage to charge the fund the same fee that an ordinary investor would pay, and then ask the broker to rebate the excess commission into their own pockets!
Or consider the practice of tape-painting. Just before the year-end closing of the mutual fund's accounting books, the mutual fund will do a ramp-job on the stocks that it has invested in, deliberate trying to push up prices so that the NAV looks better at the closing.
The mutual fund practices are just pathetic. Not to mention the fact that I do not regard their stock-picking ability very highly. True, mutual funds may get some stock choices right from time to time. But very often if not most of the time, mutual funds just invest into popular and well-known brands for no reason other than the fact that those brand names are easier to market to the public. I mean, what more can I say when Schroder Singapore Trust actually bothered to invest a large sum of capital (up to 10% of NAV at one time) into the loss-making company Chartered Semiconductors? FYI, Chartered Semicon has generated negative shareholder returns right from the start of its IPO till the present day.
Jobless recovery:
Turning away from the malfeasance and back to the macro picture, the Liscio Report did an update on the 93,000 decline in nonfarm payrolls as follows:
"The headline number, a decline of 93,000 in nonfarm payrolls, was a major disappointment, but the numbers under the surface offered no comfort either. Two months ago, we noted that we've never seen five consecutive months of job loss outside a recession; we've now got to up that to seven months. Since January, we've lost 595,000 jobs. In a real recession, we'd be losing that many every couple of months, but in a real recovery, we'd be adding that many every couple of months. Since the recession ended in November 2001, 1.1 million jobs have disappeared; were this a normal recovery, we'd have added 6.7 million. (emphasis mine)"
While employment is a lagging indicator, the continual loss of jobs and the low prospects for a turnaround bolster the assertion that the US economic recovery will not be self-sustaining. It is true that the tax cuts, the rising stock market, and until recently the home refinancing and housing boom did help things a little, but now that is mostly history and there is no longer any self-sustaining process at work in the economy. There is still the massive overcapacity that was spawned by the bubble and the prospect of continually losing jobs to the cheaper developing nations. The US national debt is now US$35 trillion compared to a US$10 trillion economy. Consumers have leveraged up purchasing homes beyond their means. But they are so pent up that even automobile sales have begun to tank even in the face of zero percent financing and numerous rebates. Companies are building up inventory without any corresponding improvement in end demand. Sooner or later folks will realize that the Federal Reserve practically has no power to alter the enormous dislocations present in the economy, 14 rate cuts notwithstanding. Yet the S&P index still trades at 30 times fantasy earnings, way above the historical average, way above previous market tops.
The mother of all bubbles:
Now, I firmly believe that we have seen the biggest stock market bubble in the history of the capital markets. The bubble we have witnessed in the years 1995-2000 was even bigger than that of 1927-1929 (just prior to the Great Depression) --- indeed, bigger than any that has happened since the founding of the USA in 1784.
During the bubble of 1995-2000, stock prices were bid up to stratascopic valuations, people pumps huge amounts of money into dubious businesses and companies embarked on expansion plans way beyond what demand was suggesting. The massive misallocation of capital, the monstrous overcapacity and excess inventory, and the huge increase in public and private sector debt, all require a lengthy convalescence that is hardly complete.
The Wall Street Journal carried a report entitled "If the Economic Recovery Loses Steam, Economy May Face Real Trouble", essentially making the above points that I have mentioned. The recent rise in stock prices (since April 2003) and all the hope that has been going on seems to be pinned on things turning around for the better. Perhaps the better-than-expected economic data (see beginning of article) might give some folks a thrill and encourage them to hang in a little longer, but I still feel this data may be nothing more than noise precipitated by the tax rebates and a feel-good mentality that has erupted since the ending of the war in Iraq.
The current bullishness, in my opinion, is misplaced. Even if we really did embark on a self-sustaining recovery (all the malaise in the economy notwithstanding), there is NO WAY THAT EARNINGS OR FUNDAMENTALS CAN EVER JUSTIFY CURRENT STOCK PRICES. Despite 3 brutal years of decline, stocks are still trading at P/E and Dividend-Yield levels that are EVEN MORE LOFTY than at previous market tops. Stock have to fall at least 50% just in order to reach the long term average for P/E and Dividend-Yield, and it is a fact that at market bottoms, stocks will overshoot on the downside --- meaning that if my opinion is correct, stocks have to decline much more than 50% to create a market bottom. The other way of course is for earnings to increase dramatically (something like over 100%) over the new few years, which given the current economic climate and all the post-bubble trauma still going around, is hardly a likely possibility.
The fact is that folks have not paid enough attention to the difference between a cyclical (short-term) move and a secular (long-term) trend. If we are in a secular bear market, as I very strongly believe, there will always be rallies like this one we've just had (April 2003 to July 2003), but they will just be brief interludes of enthusiasm.
During the secular bull market of 1982-2000, there were two declines of 20% or more. The first one was the market crash of October 1987 which was called Black Monday --- this lasted two months. The second major decline was in 1990, lasting three months. By contrast, the average duration of bear markets within the secular downtread of 1966-1982 was 16 to 17 months. Given that secular trends usually last somewhere between 10 to 20 years (based on data from 1800 onwards), we are going to have to get used to an environment very different from the one that has precended us. It is unlikely that there would be consistent gratification for either bulls or bears. When we get into dead-cat bounces like the past few months, trying to ride out the rally into profits is a very delicate procedure requiring astute market timing. On he other hand, it can be equally frustrating for the bears, as the market conforms to their expectation of failing to go up, yet disappoints by not going down convincingly.
It is the nature of bull markets to keep people out, just as it is the nature of bear markets to suck people in. It is said that bull markets climb up a wall of worry, whereas bear markets slide down a slope of hope. In the early stages of a bull market (such as the one we are seeing for physical gold and silver bullion), there is plenty of pessimism and worry, and investors are reluctant to commit large sums of money. This, in a contrarian sense, is what makes the bull market possible. In a bear market however, brief interludes of unwarranted enthusiasm drives hordes of investors back into the market, thus setting the stage for further declines and losses.
After a long and dramatic bull run, in the secular bear market that ensues (such as the current one), there is always the psychological attempt to "get even" with the market when substantial losses have been incurred. Traders and speculators keep trying to re-capture the glory of days gone by (example 1995-2000), but because it is so much more difficult to make money in the capital markets now, the victory is invariably sweeter on those rare occasions that profits are made. This is the psychology that keeps people in stocks long after it is time for them to get out of harm's way. Random, inconsistent reinforcement tends to be much more effective in motivating
repeat behaviour than reliable, consistent reinforcement. That is why it often takes so long in a bear market to get true capitulation.
We are likely to be in a secular downtrend for many more years to come. In my judgement, we are currently in a distribution top, essentially meaning that stocks are shifting from stronger hands to weaker ones. One evidence of this occurring is the significant rise in insider selling that has occurred. In the not-too-distant future, I also expect that the US dollar will face pressure. This will have positive ramifications for gold and silver, which are the only true stores of value.
All that glitters ....
Stocks aside, gold and silver might hold some ground on a "buy-and-hold" basis because this appears to be the start of a genuine bull market. These two metals are still cheap on a cost-of-production basis. An estimated US1.5 trillion worth of gold (at current market prices) has been mined since the beginning of human civilisation. It may seem like a lot of gold, but when we compare this to the fact that the debt outstanding in the US is $35 trillion and the US stock market capitalisation clocks in at $10 trillion, it's really quite small in terms of the dollars floating around --- dollars that can be created by the Fed at almost zero cost --- something that cannot happen to the metals.
The market capitalisation of silver is even smaller, at around US100 billion, with over two-thirds of the silver locked up in durable goods, art, and religious aritfacts. The rest is floating around as "liquid silver" in the form of bullion or non-numismatic coins. The silver market is so much smaller than the gold market, that's why silver has the potential to really surprise on the upside in the coming years. Essentially, the cost of silver is still below the cost of production, resulting in there being few silver mines in operation throughout the last several years. Most of the silver that has been sold has been a by-product of copper, zinc, lead and gold mining operations. Stocks of silver held by world governments has already been run down to a record low --- the persistent selling has been what has been keeping the price of the metal in check.
Silver and gold are political entities, and governments have a vested interest in keeping their prices low in order to artificially prop up the value of confetti currency and banana notes in circulation. Given the exponential increase in US debt and the continual debasement of the US currency through explicit policy actions, it is not clear how much longer this price manipulation can be effective. Sooner or later, my guess is there will be a flight to real money (that is, precious metals) as people lose confidence in the currency, in the capital markets and in the financial system as a whole. This process should work out gradually over the decade. The LTCM debacle as well as other hedge fund failures may well be the precendent of many similar financial implosions in the future set off by over-leveraging, over-speculation, and an overly lenient philosophy with regards to bank lending and Fed-engineered manipulation.
My most optimistic guess is that things will not be pleasant.
