What Happened? February 1, 2003 We have thus far only seen the opening scenes of the current economic downturn. The decline on NASDAQ, while nasty, is just a prelude of what is to come. There is a reason why the market did not heed Alan Greenspan’s warning of irrational exuberance in 1996. Perhaps if we look at why we are where we are, it will help us understand what to expect. And more importantly, what we can do to protect our financial well-being.
In 1992 the Brazilian economy buckled under debt and runaway inflation, resulting in a complete collapse of the Brazilian real. The real literally went to zero and was replaced with the new real.
During crisis money flees to the safest haven and the Brazilian crisis caused large amounts of capital to seek asylum in the U.S.. Careful analysis shows that the influx of capital from Brazil caused a noticeable uptick (about a 10% gain) in the U.S. dollar from 1992 to 1994. This marked the beginning of the greatest bull market in history, encompassing stocks, bonds and real estate.
The next year, 1995, Mexico experienced its biggest economic collapse since the Revolution and the peso lost 50% of its value. Being our southern neighbor and one of our largest trading partners, this caused additional capital to flee to the U.S., which in turn strengthened the dollar even more and our stock and bond markets followed suit. At this stage the U.S. economy was robust, real interest rates were running at 5.02% compared to Europe’s 3% and given a stronger economy and higher real rates of return, it is no surprise that capital migrated to the U.S. as economic mayhem continued to plague the world. But the stock market was already overvalued with the DOW at around 3,500.
In 1996 the South East Asian Tigers caught a bad case of the flu. This time however the net capital influx into the U.S. was staggering, totaling $356 billion during 1996 and 1997 alone. It is not a coincidence that gold peaked in February 1996 at $415 an ounce.
The world was still sniffling from Asian Flu when Russia defaulted on its debt in 1998. In January 1999 the euro was launched and promptly started falling against the dollar, eventually losing as much as 35% during the ensuing two years. More capital made its way into the U.S. attracted by reports of a “New Era,” supposedly as a result of productivity gains and the ultra-efficient U.S. economy. Not to mention the gains in the U.S. stock market from earlier flight capital infusions and of course there was still the perception of the U.S. as a safe haven for foreign capital. By this time it was already difficult to distinguish between the roaring 20's and the roaring 90's.
From 1992 to 1999 more than $1.2 trillion (net) flowed into the U.S. economy. This had to have ramifications. Initially the money was invested primarily in bonds, leading to a spectacular bull market in that sector but more importantly driving down U.S. interest rates.
The falling cost of capital had an immediate effect on the U.S. economy and the markets. Lower borrowing costs increased corporate cash flows and profits. Higher profits lead to higher stock prices as more cash flow allows companies to increase capital expenditures and R & D. The latter two stimulated the economy by increasing jobs and the velocity of money in the system.
Individuals (called consumers in the U.S.) also benefited. Unemployment declined along with mortgage rates and the interest on bank loans. Cheap access to money induced both corporations and consumers alike to take on debt at a staggering pace. From 1992 to 2002 consumer credit increased 119% and corporate debt 95%.
Bill Clinton and Alan Greenspan did not engineer the good times. They were merely bystanders, spectators and orators. The markets did not listen to Greenspan in 1996 when he warned of irrational exuberance because he could not stem the influx of capital. Greenspan also cannot alleviate the correction we are now experiencing any more than he could have prevented it. Finally, the emperor is seen for what he is.
When capital flees to the U.S. there is an increase in the demand for dollars. This increase in demand saps up dollars that would otherwise be available to settle international trade and the result is a stronger currency across the board. The dollar will obviously not increase against all currencies equally, but the point is that the dollar does not just increase against the currency in crisis, it increases against many currencies simultaneously.
As mentioned, the dollar’s run started in 1992 but it was not until 1996 that it really got going. A stronger dollar has consequences. Exports from the U.S. become more expensive, hurting the export industries. Imports get cheaper, hurting those that have to compete with lower priced, imported products like the steel industry. Lower import prices also stimulate demand for imported goods causing the balance of trade to get out of kilter. A negative $36 billion trade balance in 1992 expanded to over $420 billion by 2002.
Large trade imbalances lead to trade restrictions, which as demonstrated early in the 20th century can lead to war. But undeniably, a negative trade balance leads to a negative balance of payments. The influx of capital during the 1990's and our expanding trade deficit are two sides of the same coin as foreign demand for dollars is offset by our demand for imported goods.
The problem with an expanding negative balance of payments is that never before in the history of the world has there been a large balance of payments deficit that was not followed by a recession to correct the imbalance. The magnitude of the ensuing recession is also in direct proportion to the size of the deficit. The problem is that the balance of payment deficit in the United States today is exceptionally large by any measure. On a nominal basis it is the largest the world has ever seen.
There are several definitions of what constitutes a recession or a depression. Most common is that a recession is negative economic growth that lasts two to three quarters and a depression lasts four quarters or more. Both are of course descriptions of corrections in the business cycle. A more intelligent distinction is that a recession corrects excess inventory and a depression corrects excess production capacity, usually as a result of over expenditure on capital goods and infrastructure.
The magnitude of our balance of payments deficit suggests that we are going to have a long and severe correction ahead of us. The influx of capital into the U.S. that lowered our borrowing costs and led to exorbitant capital expenditures suggests that we are not merely looking at a recession but a full-blown depression. Doug has often commented that when this bubble blows, the aftermath is going to be dubbed the Greater Depression. I think he’s right.
So what about markets and money? If you pay attention to distortions in the economy and why they occur, there are ways to protect yourself from what’s going on. In the U.S. the foundation was laid by foreign capital influx that lowered interest rates and in turn stimulated credit expansion at an unprecedented pace, to unheard of levels. The credit expansion in turn caused asset price inflation specifically in stocks, bonds and real estate.
Bonds
Bonds have been in a bull market since 1994 driven directly by the influx of foreign capital. The steady demand for bonds has put consistent downward pressure on interest rates and the Fed’s earlier attempts at slowing the economy by raising short-term rates resulted in several episodes where the yield curve became inverted.
An inverted yield curve is potentially disastrous for the banking sector as banks make a living by borrowing short and lending long. This disarms the Fed somewhat in that it cannot raise short-term interest rates above long-term rates for too long without causing stress to the banking industry or without intervening in the bond market to drive up long-term rates as well.
Therefore, during the 1990's when long-term interest rates were dropping, the government did everything in its power to show that inflation was under control; thereby obviating the necessity to raise short-term rates. Because of the strengthening dollar and rising imports, we were importing deflation and exporting inflation of a sort but the inflationary impact of the credit expansion in the U.S. was clearly evident in the stock market and later in the real estate market as well.
Typically the bond market warns of impending inflation but in this case the bond market was being distorted by foreign demand, almost at any price, since it was flight capital focused on capital preservation and not necessarily the highest possible returns. Instead of acknowledging what was going on, the government and the Fed irresponsibly tried to justify the robust bond market by convincing Joe and Joanne Public that inflation was nowhere in sight. I don’t know whether this was out of malice or ignorance but I do know that inflation was very much a concern judging from the increase in money supply, as a result of credit expansion and soaring asset prices on Wall Street and Main Street.
If you don’t agree with me that inflation really was a problem during the previous decade answer me this: We are currently facing a deflationary dilemma. How could we have a problem with deflation if there was no prior inflation to create overvalued asset prices?
The Fed is terrified of deflation because it has limited ability to combat it. Especially after shooting out most of its interest-rate-cut arrows already. But the Fed has made it clear that it will do whatever it takes to fight this deflation. That means that interest rates are likely to remain at historically low levels in as much as the Fed can control them. Remember, the Fed sets short-term interest rate targets but the markets determine the actual interest rates. Only by buying or selling bonds can the Fed change the actual interest rates and since private capital in the markets is substantially more than what the Fed could lay its hands on, the Fed’s ability to intervene is restricted to the short-term only.
Nonetheless, interest rates in the foreseeable future are likely to remain low because of the deflationary environment we find ourselves in and the Fed’s resolve to fight it. But when medium and long-term rates do start to rise, brace yourself. The Fed is almost surely going to go overboard in its war against deflation and the ensuing inflation will cause serious damage to the unprepared. So please be careful not to overstay your welcome in the bond market.
Stocks
U.S. equity markets have declined for three straight years now; the worst performance since 1977. But in a typical display of ignorance, mainstream media is still focused on issues such as war and corporate governance to try and explain why the much-anticipated resumption of the bull market did not occur. It's like observing that someone with an infection has a fever but not being able to recognize the fever is due to an infection.
As mentioned, the influx of foreign capital had a stimulating effect on the U.S. economy that set the stage for the bull market in stocks. But the real damage was caused by excessive credit expansion that increased the money supply and abundant, cheap money leads to a mentality of gambling. Investors weren’t investing during the late 90's, they were speculating in the stock market on the greater fool theory.
The reason why the bull died is not because of the threat of war or corporate governance in America. Both of these are consequences of the bull market. Stock prices simply became over inflated as more and more cheap money was given to inexperienced money managers who all read The Complete Idiot’s Guide to Investing and Getting Rich Quick.
From 1996 to 1999 prices on Wall Street had no connection to the reality of running a business or the value of the companies they represent. America’s desire to gamble created an environment in which only the most aggressive corporate executives could thrive and the corporate governance issues blamed for the decline in stocks are in reality not the reason for the decline, but a result of excessive demands from greedy and ill-advised investors.
Bush probably realizes that there is nothing he can do to stop the decline on Wall Street or the slumping economy so he is trying to distract the world with war games. I can think of other reasons why he is hell bent on invading Iraq but I am quite sure the aforementioned ranks high on his list of reasons. War has in the past been able to boost economic activity but it won’t work this time. We’ll get to that later.
In spite of declining 36% since 1999, the average P/E for the DOW is still 26. The problem is that E is declining along with P and so the excess valuations on Wall Street are not yet corrected by any stretch of the imagination. Hence the bear market is far from over.
Do not rush back into the stock market. Wait for fundamental value to become apparent and because there will be far fewer investors around, you should have plenty of time and many opportunities to evaluate before investing in general equities again. I for one look forward to having a target rich environment in stocks.
At heart I am a fundamental investor but the past decade has not been fertile ground for such an approach.
Real Estate
According to data supplied by the Department of Housing and Urban Development, average home prices in the U.S. increased by 44% from 1991 to 2001. But unfortunately statistics sometimes have a tendency to obscure important trends. As with stocks, the rapid increase in money supply has led to speculation and gambling in real estate markets. In San Diego County, where I live, house prices have risen 83% since 1998 and anecdotally I can tell you that in some areas house prices have more than doubled during the past five years. I recently sold my house and am now living in a rental because property values are so absurd.
Nonetheless, I expect interest rates to stay low and mortgage rates to do the same even though I would not be surprised to see them edge upwards a little.
While I do not pretend to be an expert in real estate, I do believe that the expansion of mortgage loans and, more importantly, the decline in the quality of these loans, will eventually have a dramatic negative impact on real estate prices across the country.
Greenspan reminded investors some time ago that even though Freddie Mac and Fannie Mae were sponsored by the government, investors were not protected against losses by any form of government insurance.
Why would he do that?
In a recent Wall Street Journal article it was noted that Freddie Mac and Fanny Mae both passed risk based capital requirements. But if you read the article, it’s scary as hell. While both had more capital than regulations require, according to minimum capital standards established by Congress in 1992, Freddie Mac exceeded its capital requirements by only $2.1 billion and Fannie Mae by a mere $729 million as of September 30, 2002. Those are rounding errors on these companies’ balance sheets.
Fannie Mae has assets of $838 billion. It’s equity base of $15 billion is only 1.8% of its assets, which means that a minor decline in asset values can easily wipe out the equity. In fact, Fannie Mae's equity has already declined 27% from the 1st quarter of 2002 to the 3rd quarter. Freddy Mac is apparently in better shape than its much bigger cousin. But that's not very reassuring.
Also, Freddie Mac and Fannie Mae have been instrumental in the capital expansion of the past decade that I have referred to so frequently. Since 1992 Fannie Mae's assets have grown by 363%; from $181 billion to $838 billion as of the 3rd quarter of last year.
Freddie Mac and Fannie Mae contribute to credit expansion by buying securitized mortgages from mortgage lenders thereby enabling the mortgage lenders to create more mortgages. Because of the leverage (the low capital reserves to assets) that Freddie Mac and Fannie Mae have and their ability to expand by selling new equity on the stock market, they are perfect vehicles for inflating the money supply. Both are also time bombs and both are also heavily involved with derivatives.
Remember Long Term Capital Management? If Fannie Mae goes, LTCM and Enron will look like kindergarten tea parties.
The real estate market has too much debt secured by over-inflated real estate prices as a consequence of low interest rates and rapid credit expansion. A collapse could be averted by massive inflation but that is easier said than done. Just ask the Bank of Japan. In the meantime, if real estate prices start falling along with a slowing economy, look for the record number of bankruptcies that we already have to go hand in hand with record foreclosures and it is precisely these foreclosures that are going to drive down real estate prices.
I would be inclined to stay far away from most real estate speculations and investments in the U.S. right now unless you are an exceptionally sophisticated and experienced real estate investor.
Even though I sold my house, this discussion is not necessarily relevant to most people’s primary residences. After all, a house does have utility value over and above its investment value and a person does need a place to live. Given the low interest rates I would be inclined towards a 30-year fixed mortgage on a primary residence and to invest the excess capital in a safe place. I suspect that within a few years the government will not be able to borrow money at current mortgage rates. The fact that mortgage interest is tax deductible and the fact that most of the payments initially consist almost entirely of interest, should enable you to generate a positive spread on the mortgage. Just don’t lose the money.
Gold
Prior to 1971 the gold price was set by decree, which means that it could not respond rapidly to changes in the economy or the value of the fiat currency it was But when Nixon closed the gold window the price of gold had to incorporate not only what was happening at the time, but also decades’ worth of inflation that had never been factored in. As a result, the gold price shot up from $38 an ounce to over $750 an ounce in less than ten years. That was an overshoot and the gold price retraced to the mid-$300’s before settling into a trading range around $380 an ounce by the mid-1980's. For the next decade, until 1996, the gold price remained relatively stable trading in a narrow price range around that price.
The steady decline in the gold price from 1996 to 1999 was not due to central bank sales, forward sales by producers and short sales by speculators, or manipulation by a cartel. Yes, all these contributed to the decline but they were not the primary reason for the decline. Gold, like all other U.S. imports, got cheaper because of the strengthening dollar. While the dollar gold price declined, the gold price in many other currencies did not.
From 1996 to 1997 the gold price soared in Indonesia, Thailand, Malaysia and several other countries as their currencies collapsed at the same time as the gold price started falling in the U.S. Thereafter gold soared in Russia and all the while the South African gold price was steadily increasing as the rand devalued. But gold still declined in the U.S.
It makes no sense to think about the worldwide gold price in only one currency because under the current system of free floating currencies, the gold price changes rapidly in different countries depending on the strength of the local currency. The decline in the gold price from 1996 to 1999 was due to the strength in the dollar, which in turn was due to the currency crises sweeping the globe. This is not coincidence; these are parts of the same mechanisms at work.
By 1999 the dollar had just about topped out and the gold price in U.S. dollars had bottomed. Since then gold is up 45% as the dollar buckles under the pressure of our gigantic trade deficit and upside-down balance of payments. We have already discussed how the dollar’s gain during the 90's was due to external crises that increased demand for dollars and how that led to the expansion of the U.S. economy and ultimately to soaring stock, bond and real estate markets. Throughout this time, gold in U.S. dollars did poorly since the price of gold, when quoted in U.S. dollars, is nothing more than a reflection of the dollar’s strength against other currencies.
The dollar is taking a lot of strain now that the U.S. economy has to stand on its own two feet and deal with all the debt that was created under the false impression that consumerism is the cure for all economic disease. And that is likely to continue. In order to put our trade balance and balance of payments in order would more than likely take a further 15% to 25% decline in the dollar. This in turn will cause the dollar-gold price to increase by a comparable amount, to around $450 an ounce.
The single best asset class available to all investors today, one that has the ability to protect your financial health for the next decade, is gold. Gold has traditionally played this role and more recently, in all the cases mentioned where economic turmoil and financial crises ruined millions, it was the one financial asset to retain its purchasing power. Those with gold in Latin America were able to preserve their wealth, ditto for Mexico, South East Asia, Russia and South Africa. Now it’s North America’s turn; what will you do?
But the worldwide gold price is not just dependant on currency fluctuations. Gold also responds to stresses such as war. In fact the average gold price in the world has steadily been increasing since 1998, even before the U.S. dollar-gold price rebounded. For a detailed look at the average worldwide gold price please refer to "Making Sense of the gold price” which can be found on our website at
www.dougcasey.com, under the Topical Comments section.
By the way, I don't think that $450 is the highest that gold will go, but that's a discussion for another day.
War
Bush is determined to go to war and Iraq is just an appetizer. The enemy has been defined as terrorists and anyone supporting terrorists. But that’s a loose definition. Since Bush made his War on Terrorism speech governments across the world have been branding their enemies and opposition as terrorists.
The enemy has intentionally been loosely defined so that there will never be a shortage of enemies. There is no doubt in my mind that we are going to war. Iraq is first, but not last. War destroys economic prosperity. Capital that could be used for research and development, infrastructure and expansion now gets allocated to bullets, bandages and missiles. This reduces economic growth and constricts economic expansion for long after the war is over.
Back in the days of conventional warfare when thousands of tanks, battleships and airplanes were required, war spending could give the economy a boost as hundreds of thousands of workers assembled weapons. But today, with our expensive, high-tech weapons, the economic benefits of war are going to be far less. Far fewer weapons are produced at a much higher cost. That means the employment benefits are less and the financial loss, when the weapons are spent or destroyed, is huge. This war is going to cost the United States big time.
Bottom Line
The expansion of the 90's was due to tremendous capital flight that found its way to the U.S. and boosted the dollar. This led to humongous credit expansion, a trade deficit and an unsustainable balance of payments deficit. When the influx of capital stabilized, the U.S. found itself with a stock market bubble, absurd real estate prices and crushing debt.
Foreign capital has not yet left the U.S. en masse, as evidenced by our still negative balance of payments. But it is becoming ever more difficult to attract new foreign capital on economic and investment merits. Bush is not helping either, by changing the previously favorable U.S. climate for foreign capital to a perilous one with terrorism related seizures and the freezing of accounts.
The U.S. economy is stumbling over a cliff and it’s going to take the dollar with it. The result will be slower, or negative, economic growth, collapsing stock and real estate markets and spectacular bankruptcies.
This collapse in asset prices creates deflationary pressure that the Fed is going to fight tooth and nail with as much money creation as possible. That will ultimately lead to a real inflationary problem that could be far worse than anyone is currently imagining. Navigating through this investment environment will not be easy.
Fortunately there is hope. The future is bleak for the dollar whether we face inflation or deflation. That is because during the current deflationary period, U.S. economic growth is grinding to a halt, thereby reducing the allure of U.S. stocks, bonds and real estate to foreign investors. As foreign investors reduce their investment in the U.S., the dollar will fall. To combat deflation the Fed is going to try to devalue the dollar, which is obviously bad for the dollar.
Since gold acts as a stable international monetary asset and since the gold price in U.S. dollars is inversely proportional to the U.S. dollar exchange rate, the gold price will increase as the dollar falls.
Furthermore, war games around the world are likely to cause the average gold price to increase as well, further increasing the U.S. dollar gold price. The question should not be whether to own gold or not, but how to invest in gold and related assets.
(This article was written for Doug Casey's International Speculator Volume XXIV No. 2)
Paul van Eeden
Disclaimer This letter/article is not intended to meet your specific individual investment needs and it is not tailored to your personal financial situation. Nothing contained herein constitutes, is intended, or deemed to be -- either implied or otherwise -- investment advice. This letter/article reflects the personal views and opinions of Paul van Eeden and that is all it purports to be. While the information herein is believed to be accurate and reliable it is not guaranteed or implied to be so. The information herein may not be complete or correct; it is provided in good faith but without any legal responsibility or obligation to provide future updates. Neither Paul van Eeden, nor anyone else, accepts any responsibility, or assumes any liability, whatsoever, for any direct, indirect or consequential loss arising from the use of the information in this letter/article. The information contained herein is subject to change without notice, may become outdated and will not be updated. Paul van Eeden, entities that he controls, family, friends, employees, associates, and others may have positions in securities mentioned, or discussed, in this letter/article. While every attempt is made to avoid conflicts of interest, such conflicts do arise from time to time. Whenever a conflict of interest arises, every attempt is made to resolve such conflict in the best possible interest of all parties, but you should not assume that your interest would be placed ahead of anyone else’s interest in the event of a conflict of interest. No part of this letter/article may be reproduced, copied, emailed, faxed, or distributed (in any form) without the express written permission of Paul van Eeden. Everything contained herein is subject to international copyright protection. |
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